Press Releases


For Immediate Release: Tuesday, August 01, 2006
Contact: CMS Media Relations


On August 1, 2006, the Centers for Medicare & Medicaid Services (CMS) issued the hospital inpatient prospective payment system (IPPS) final rule for fiscal year (FY) 2007.  In this rule, CMS identified the goals of

  • making meaningful first steps in diagnosis-related group (DRG) reform in FY 2007, while having further plans to continue reforms in FY 2008;
  • taking needed steps toward more accurate payments, without disrupting hospital payments;
  • ensuring that Medicare does not overpay for some services while underpaying for more severely ill patients and those with complex illnesses; and
  • correcting inappropriate hospital incentives for treating certain types of patients and providing certain types of services, by re-directing a portion of the payments from cases that are currently overpaid to those that are underpaid.


Key Policies for FY 2007 Final Rule

  • Implement the first year of a three year transition for cost weights, including significant technical improvements to the payment methods based on public comments, and assess potential for further improvements for FY 2008 based on a contractor analysis of issues raised in public comments.
  • Make meaningful refinements to the current CMS classification system to increase recognition of severity of illness, including 20 specific DRG changes;   and
  • Conduct an evaluation with public comments of alternative severity adjustment systems for implementation in FY 2008.


Main Impacts:

  • There will be limited hospital payment impact because of the simultaneous implementation of incremental reforms for cost-based and severity-adjusted payments. 
    • More specifically, payment to all hospitals will increase by an average 3.5 percent in FY 2007 or by more than $3.4 billion.
    • Only 2 percent of hospitals have a projected reduction in payment as a result of the overall rule, and factors other than the DRG changes (particularly certain wage index changes) account for these reductions.


  • There will be a limited impact on payments in specific DRGs.
    • No DRG weight will decrease more than 5.4 percent in FY 2007.   DRG weight reductions are less than in the proposed rule because of methodological changes suggested by commenters.
    • Nineteen DRGs weights increase by more than 5 percent as compared to the current weight methodology in the first year.


  • Changes to improve the IPPS are widely-supported because they will help assure that all beneficiaries have access to appropriate, high-quality care. 
    • The Medicare Payment Advisory Commission (MedPAC), an independent body that advises the Congress on Medicare payment policy, supports these reforms.
    • The types of payment changes being implemented were described as “promising” in a recently released Government Accountability Office (GAO) report.


  • The final rule represents a meaningful step towards DRG reforms that are needed to assure that all beneficiaries have access to quality care, while minimizing disruptions through a multiyear transition and the simultaneous implementation of severity and cost-based payment changes, as suggested by many who commented on the rule.


Background:   Importance of Inpatient Payment Reforms for FY 2007 and FY 2008 for Providing High-Quality Care for All Medicare Beneficiaries


This final rule begins to implement the most significant revision of Medicare’s inpatient hospital rates since 1983. These reforms are measured steps to improve the accuracy of Medicare’s payment for inpatient stays by better reflecting costs rather than charges and by adjusting payment to better account for the severity of the patient’s condition.  The changes will better align payment with the cost of care, by increasing payments for some services and decreasing payment for others in a way that adds up to only limited impacts at the hospital level, but significantly more accurate payment for each patient treated by the hospital.  The reforms will eliminate biases in the current system arising from the hospital practice of charging much higher than their costs for some services.  These biases have led to the development of specialty hospitals and general acute care hospitals to specialize in the most profitable and overpaid services at the expense of other needed but poorly paid cases.  As a result, some patients may have more difficulty getting high-quality care, while other better-paid services may be provided excessively.  The reforms address concerns that specialty hospitals and other hospitals may focus on certain services and patients because of the relatively favorable reimbursement.


Payments Based on Costs Instead of Charges


CMS proposed to base the relative weights on hospital-specific costs rather than on charges.  The limitations of charges as a measure of resource use are well known, among them the fact that hospitals markup charges over costs in many different ways that bear little relation to cost.  Hospitals tend to cross-subsidize various departmental services, frequently applying a lower markup to routine and special care services than they do to ancillary services.  This approach not only impairs transparency in hospital payments; it also creates potential problems in access to needed services by beneficiaries in the low-markup, underpaid DRGs.  Earlier this year, CMS proposed to address these payment inaccuracies by adopting cost-based DRG payments based on accounting for the differential mark-ups between costs and charges for 10 individual hospital departments.


While this methodology addresses the effects of cross-subsidization, CMS noted in the proposed rule that it expected to refine the cost-based payment methods to address a range of issues based on public comments, and the final rule includes such refinements.   For instance, CMS applied less stringent statistical trimming criteria to include more high cost hospitals in the calculation of national average cost to charge ratios.  We also weighted these calculations to account for hospital size.  One refinement involves addressing potential bias in cost-based weights due to charge compression, the practice of applying a lower percentage markup to higher cost services and a higher percentage markup to lower cost services.  The public comments provided evidence that the hospital-specific relative weight methodology exacerbates the effect of charge compression on the final relative weights and results in payment for technology intensive DRGs that is inappropriately low.  CMS is not using a “hospital-specific” methodology in part for this reason.  In addition, CMS has engaged a contractor to further study charge compression, including a suggestion in the public comments for how to adjust for it and steps to develop more transparent information on device costs.  CMS will use the results from the contractor’s research to determine whether further steps are needed as the cost-based methodology continues to be phased in during FY 2008.


Comments also suggested that the cost report data used in the cost methodology is outdated, not consistent across hospitals, and does not account for the costs of newer technology.   However, the relationship between costs and charges (not costs alone) is the important variable in setting Medicare’s payment under this new system.  Older cost reports also do not include the hospital’s higher charges for these same devices, and so the need to adjust for newer cost or charge information exists under all payment methods.  CMS expects to continue to use add-on payments for new technologies to assure more timely adjustments for important but costly new technologies. The use of average rather than hospital-specific cost to charge ratios, addresses variations in hospital cost reporting.  CMS is also using FY 2004 cost reports to calculate national average cost to charge ratios for the final rule instead of the FY 2003 cost reports we used for the proposed rule.


MedPAC recommended separately distinguishing anesthesia, labor and delivery, and inhalation therapy because of the significant variation between the ratio of costs and charges for these areas compared to the departments where they were included in the proposed rule.   In the final rule, to further improve accuracy and in response to the comment from MedPAC, CMS expanded the number of hospital departments to 13. 


The changes to the statistical trimming, the weighting of national cost-to-charge ratios, and removing the hospital-specific portion from the weighting methodology will result in smaller changes in payment, up or down than the proposed rule.    Further, CMS is implementing the cost-based weighting methodology gradually, by blending the cost and charge weights over a three-year transition period.  As a result, not only are ultimate payment impacts considerably more moderated compared to the proposed rule, the gradual implementation also helps minimize any disruptions and ensure smooth adoption.


Payments Based on Better Accounting for Severity of Illness


Earlier this year, CMS proposed to adopt refinements in accounting for patient disease severity, in order to prevent underpayments for caring for the most severely ill patients.  The proposed options included adopting CS-DRGs that would replace the current system of 526 DRGs with 861 refined DRGs, as well as other options for timing and content of a refined severity adjusted system.   This included asking for public comments on whether alternatives to the proposed CS-DRGs should be evaluated before a full refined severity adjusted system is adopted.  In addition, CMS raised the possibility of making revisions to the current DRG system to better recognize severity of illness for FY 2007.  In response to the public comments, CMS is taking the following actions to improve the DRG system’s recognition of severity of illness:


FY 2007 DRG Changes to Improve Recognition of Severity of Illness.   CMS identified 20 new DRGs involving 13 different clinical areas that would significantly improve the CMS DRG system’s recognition of severity of illness.  The final rule also modifies 32 DRGs to better capture differences in severity.  The new and revised DRGs were selected from 40 current DRGs which contain 1,666,476 cases and represent a number of body systems.  In creating these 20 new DRGs, CMS is deleting 8 and modifying 32 existing DRGs.  CMS is taking these interim steps in FY 2007 as a prelude to making more comprehensive changes to better account for severity in the DRG system by FY 2008. 


Further Improvements Planned for FY 2008.   Through a research contractor, CMS will conduct an evaluation of alternative DRG severity systems, with opportunity for public input.  Based on this evaluation, CMS expects to implement one of these systems, or potentially a system that CMS develops based on its own prior research, to achieve further improvements in payment accuracy by FY 2008.  The contract to evaluate severity-adjusted DRG systems will be awarded by September 1, 2006.  An interim report comparing severity-adjusted DRG systems will be completed by the end of 2006 and will be released for public comment.  A Technical Advisory Panel to consider the interim report would then be convened in January 2007.  Results of the evaluation research contract would then be available to inform deliberations about the IPPS rule for FY 2008.


Specialty Hospitals


These proposed revisions will improve the accuracy of payments, leading to better incentives for hospital quality and efficiency and ensure that payment rates relate more closely to patient resource needs.   More specifically, these changes are expected to reduce incentives for hospitals to cross-subsidize underpaid cases by having to treat the most profitable patients.  In FY 2006, CMS made significant changes to the cardiovascular DRGs that are commonly billed by specialty hospitals to better recognize severity of illness.  The FY 2007 changes take this initiative further.  As a result of the DRG payment reforms to improve accuracy, between FY 2006 and FY 2009, payment to cardiac specialty hospitals are projected to decline by over 5 percent due to the changes to the relative weights.


Details on Hospital and DRG Impacts


Medicare payment to 98 percent of hospitals will increase in FY 2007.    The reduction in payment to the remaining 2 percent of hospitals is occurring as result of factors other than the changes CMS is making to improve the accuracy of the IPPS (generally updates to the wage index data etc…).  No hospital is projected to experience an estimated decrease in payment in FY 2007 from the change to adopt cost weights after including the market basket update


# of Hospitals

Changes in total estimated payments

FY 2006 to FY 2007

Percent Gains/Losses in Specific Ranges















Market Basket














More than  -10%




Between -5 and -10 %




Between -1 and -5 %




Between -1 and 0




Between 0 and +1 %




Between 1% and 5%




Between 5% and 10%




More than  +10%





The changes in the DRG relative weights are budget neutral.  Therefore, some will go up and others will go down from the changes we are making.  As suggested earlier, the changes we are adopting in this final rule result in few changes, up or down, relative to our proposed rule as illustrated below.


# of DRGs

Changes in the Relative Weights

Percent Gains/Losses in Specific Ranges





  Proposed Rule

Final Rule

More than  -10%



Between -5 and -10 %



Between -1 and -5 %



Between -1 and +1 %



Between 1% and 5%



Between 5% and 10%



More than  +10%




Page Last Modified: 12/02/2011 12:00 PM
Help with File Formats and Plug-Ins

Submit Feedback