How Hospitals Get Paid a Fixed Price Per Case: DRGs and Activity-Based Funding

Under a diagnosis-related group system, a hospital is paid one fixed price for a case, set by the patient's diagnosis and procedure category rather than by the specific tests, drugs, and bed-days actually used. This is the core of activity-based funding: the payer decides in advance what an average appendectomy or hip replacement is worth, and the hospital keeps the difference if it treats the patient for less, or absorbs the loss if it spends more. The design rewards efficiency and throughput, but it also rewards doing more cases and coding each one as favorably as the record allows. A 2024 review in Health Policy examining ten high-income countries found many of them now deliberately reducing how much of hospital income flows through this mechanism.

From cost reimbursement to a price per case

To see why DRGs exist, it helps to see what they replaced. Under older cost-based and fee-for-service arrangements, a hospital was paid for the inputs it consumed: more tests, more days, more line items on the bill meant more revenue. That structure has an obvious problem, because it pays more when more is done regardless of whether the extra activity helped the patient.

The United States confronted this directly in 1983, when Medicare replaced cost reimbursement with the Inpatient Prospective Payment System. According to the Centers for Medicare and Medicaid Services, a hospital admission is now grouped into a clinical category, and the hospital receives a predetermined rate for that group, with separate handling for unusually expensive outlier cases. The underlying DRG logic was developed at Yale in the early 1970s and first used at scale by New Jersey before Medicare adopted it nationally. Most wealthy countries later built their own versions, adjusting the classification and the price weights to local costs.

The shift matters because it moves financial risk. Fee-for-service places the cost risk on the payer, since every additional service is reimbursed. A fixed price per case places the cost risk on the hospital, since anything spent above the set price is the hospital's loss. That single change is what makes DRGs a tool for controlling spending.

What a fixed price per case actually rewards

A prospective price per case creates a clear and mostly intended incentive to treat each admitted patient efficiently. If the payment is fixed, the hospital has reason to avoid duplicate tests, shorten unnecessarily long stays, and standardize care around what works. Much of the appeal of activity-based funding is exactly this pressure toward productivity, and it comes with transparency, because a DRG system produces a common language for comparing what hospitals do and what it costs.

The incentives that trouble policymakers sit alongside these gains.

The first is volume. Efficiency per case is rewarded, but so is the number of cases. When each admission carries its own price, an obvious way to raise revenue is to admit and treat more patients. Whether that added activity is clinically warranted is not something the payment formula can judge on its own.

The second is coding. The price attaches to how a case is classified, so the same patient can map to a better-paid group if the record emphasizes a more complex diagnosis or a qualifying complication. This is where the well-documented phenomenon of upcoding enters. A study of roughly 145 million French hospital stays, published in 2021, showed that introducing a finer DRG classification produced an upcoding-learning effect that gradually shifted funding between hospital types even though the care delivered had not changed. The lesson is that coding is a lever, and where a lever exists, some organizations will pull it.

Neither incentive requires anyone to act in bad faith. Both follow from paying by classified activity, and both are why DRG systems are typically paired with audits, coding rules, and volume monitoring.

Why several countries are revisiting the model

The 2024 Health Policy review by Milstein and Schreyogg, titled with the pointed question of whether this is the end of an era, traced a consistent pattern of reform across the ten countries it studied. Rather than abandoning activity-based funding, these systems are diluting and supplementing it in four recurring ways.

• Lowering the DRG share. Several countries have reduced the proportion of inpatient income that depends on per-case activity, blending in fixed budgets or population-based elements to soften the volume incentive.
• Protecting rural hospitals. Because a small rural hospital cannot achieve the case volumes a per-case price assumes, countries have added supplementary payments for these facilities or exempted them from the standard DRG structure.
• Episode-based payments. Instead of paying separately for each admission, some systems pay a single bundled price covering the full pathway of care, which discourages fragmenting one episode into several billable events.
• Steering care to lower-cost settings. Financial incentives increasingly encourage moving suitable care out of the expensive inpatient ward toward day surgery or outpatient settings.

The review describes this as a move away from rewarding activity and efficiency alone toward a more diversified set of goals, including quality and care coordination. It is candid that the evidence on whether these reforms improve quality or reduce spending is mixed. That honesty is the useful part. There is no payment model that is simply correct, because every method rewards whatever it measures and stays blind to whatever it does not. Fee-for-service rewards volume of services; a fixed price per case rewards volume of cases and favorable coding; a global budget rewards staying under budget, which can mean doing less. Reform is less about finding a flawless design than about choosing which distortions a system is willing to manage and monitor.

For a reader trying to make sense of hospital-financing debates, the practical takeaway is to ask what any given payment rule pays for, and therefore what it quietly encourages. A DRG pays for a classified case, so it encourages more cases and cleaner-looking codes. Knowing that is enough to read the current reforms not as a repudiation of activity-based funding but as an effort to blunt its sharpest edges. This article is educational and not medical advice.