Paying Hospitals

Before 1983, Medicare paid hospitals their reported costs. A hospital that spent more was paid more, which is the purest possible incentive to spend. The inpatient prospective payment system replaced that with a fixed payment per discharge, and in doing so created the first large-scale demonstration that changing how you pay changes how care is delivered.

The core mechanic

Section 1886(d) of the Social Security Act “sets forth a system of payment for the operating costs of acute care hospital inpatient stays under Medicare Part A (Hospital Insurance) based on prospectively set rates.” Under the system:

• Each case is assigned to a diagnosis-related group. “Each DRG has a payment weight assigned to it, based on the average resources used to treat Medicare patients in that DRG.” Medicare uses Medicare Severity DRGs, which subdivide base groups by severity of illness.
• The base rate is split and adjusted for geography. “The base payment rate is divided into a labor-related and nonlabor share. The labor-related share is adjusted by the wage index applicable to the area where the hospital is located.” For FY 2026, CMS established “a national labor-related share of 66%.”
• The adjusted base rate is multiplied by the DRG relative weight. That product is the payment for the stay.

A hospital that treats the case for less than the payment keeps the difference. A hospital that spends more absorbs the loss. The financial consequence of length of stay and resource use moved onto the hospital in a single stroke.

The adjustments that follow

Pure per-case payment would be unworkable, so several adjustments sit on top:

• Disproportionate share. A hospital treating a high share of low-income patients “receives a percentage add-on payment applied to the DRG-adjusted base payment rate.”
• Indirect medical education. An approved teaching hospital receives an add-on that “varies depending on the ratio of residents-to-beds.”
• Outliers. For “particular cases that are unusually costly, known as outlier cases, the IPPS payment is increased,” which protects hospitals “from large financial losses due to unusually expensive cases.”

The outlier policy is worth noticing, because it is stop-loss protection built into an administered price system. The finance course covered the same concept in the context of provider risk contracts, and it appears here for the same reason: fixed payment against variable cost requires protection against the tail.

The annual update

Payment rates are updated each year through notice-and-comment rulemaking. For FY 2026, “the increase in IPPS operating payment rates for general acute care hospitals that successfully participate in the Hospital Inpatient Quality Reporting (IQR) program and are meaningful electronic health record (EHR) users under the Medicare Promoting Interoperability Program is 2.6%. This reflects a projected FY 2026 hospital market basket percentage increase of 3.3%, reduced by a 0.7 percentage point productivity adjustment.”

Worth remembering: two features of that sentence carry the whole logic of Medicare payment policy. The market basket measures what hospital inputs cost, so it is an inflation adjustment. The productivity adjustment subtracts an assumed efficiency gain, so it is a standing requirement that hospitals get more efficient every year whether or not they do. And the full update is conditional on quality reporting and interoperability participation, which is how Medicare attaches behavioral requirements to a price it was going to set anyway.

Key takeaways

• IPPS pays a fixed amount per discharge: a wage-adjusted base rate multiplied by the DRG relative weight.
• Add-on payments for disproportionate share, indirect medical education, and outlier cases modify the result.
• The FY 2026 update was 2.6 percent, a 3.3 percent market basket increase reduced by a 0.7 percentage point productivity adjustment.
• The full update is conditional on quality reporting and interoperability participation.

Sources

• CMS, Acute Inpatient Prospective Payment System (opens in a new tab)
• CMS, FY 2026 Hospital Inpatient Prospective Payment System Final Rule (CMS-1833-F) (opens in a new tab)