By Toni Cesta, PhD, RN, FAAN


This month, we will continue the discussion of healthcare reimbursement by third-party payers. We began last month with a review of the diagnosis-related groups (DRGs) and associated terminology. We will continue by reviewing how medical records are coded followed by the new MS-DRGs implemented in 2007.

DRG Assignment

Once a patient is discharged from the hospital, the medical records department picks up the process. Specially trained coders review the record and look for the following elements in the documentation. Coders must identify these elements to determine the DRG assigned to that record:

  • The principal diagnosis (or primary diagnosis) is what the physician determined to be the chief reason the patient was admitted. Coders also look for the major diagnosis, which is the diagnosis that consumed the most hospital resources. The principal diagnosis and the major diagnosis cannot be the same.
  • Coders identify the secondary diagnosis, which also relates to resource consumption.
  • Coders note the principal procedures used to treat the chief complaint or complication rather than those performed for diagnostic purposes. In the case of multiple procedures, the one most closely related to the principal is the principal procedure. All other procedures are considered secondary.
  • Non-diagnostic operating room procedures also are considered principal procedures.
  • Comorbidities and complications also are considered.
  • One-fifth of DRGs are determined by age. Age 65 years is a demarcation line for some.
  • Discharge status also is considered. This refers to the patient’s final destination after discharge, such as a nursing home, home, or home with other services.

As a case manager or utilization review nurse, this information is not necessary to perform the job. However, you should understand how these are determined as you sometimes might be required to prospectively identify the expected length of stay. Case managers also are obligated to ensure the documentation in the medical record reflects the care actually rendered to the patient, as well as the acuity level. Documentation improvement specialists also are responsible for ensuring the documentation reflects the care provided, the patient’s acuity, and the resources used. Case managers and clinical documentation specialists should establish a good working relationship as each role complements the other.

Complex patients, either due to acuity or resource consumption, are coded into a higher-weighted DRG, but not without the complete documentation needed to support the code. Coders cannot work based on assumptions. They are completely reliant on the documentation alone and cannot draw their own conclusions.

Other Uses of DRGs

Some states use DRGs to set per diem rates. States with these rate-setting programs use the DRGs and adjust their per diem rates accordingly. Some states are DRG-exempt for identified categories such as:

  • Psychiatry;
  • Pediatrics;
  • Specialty hospitals (e.g., cancer hospitals).

Calculating Payments

Payments are calculated by multiplying the relative weight by the reimbursement rate, which is determined annually. As each DRG carries a relative weight, the weight is used for the multiplier.

Example 1: Average Relative Weight

  • Payment = Relative weight × current base rate;
  • Payment = 1.0 × $1,000;
  • Payment = $1,000.00.

Example 2: Light Relative Weight

  • Payment = Relative weight × current base rate;
  • Payment = 0.5 × $1,000;
  • Payment = $500.00.

Example 3: Heavy Relative Weight

  • Payment = Relative weight × current base rate;
  • Payment = 22 × $1,000;
  • Payment = $22,000.00.

Dollar figures are for example only and illustrate how the calculations are made. They do not reflect actual hospital reimbursements.

How DRGs Affect the Healthcare Industry

The advent of the prospective payment system and the DRGs started the shift of case management into the acute care setting. Other changes occurred in response to this reimbursement system, including shifting many procedures to the outpatient setting. For some low relative weight DRGs, there are more financial benefits for the hospital to perform procedures in outpatient and ambulatory settings. In general, the per diem rate will reimburse less than the DRG payment. Because of this, many hospitals opened same-day surgery programs, ambulatory or day surgery facilities, and outpatient dialysis.

Reducing Length of Stay

To optimize the DRG case rate payments, healthcare institutions changed their practices on the preadmission and post-discharge sides of an inpatient admission. Managing length of stay required handling these other processes as well. Preoperative or preadmission testing departments were created to address the patient’s preadmission needs. The expense to the hospital was less on the inpatient side, and presurgical tests also could be billed. Similarly, the better the discharge planning process, as well as the availability of community-based programs, the sooner the patient could be discharged home or to a lower level of care.

DRGs Today

The latest DRG version (version 25) was created in 2007, called the Medicare Severity DRGs (MS-DRGs). Three tiers were created for some DRGs, including no CC (complication or comorbidity), the presence of a CC, or the presence of a major CC. The historical list of diagnoses that qualified for inclusion on the CC list was replaced with a new, standard CC list and a new major CC list.

Another change is the elimination of the strict numerical sequencing of prior versions. Before, newly created DRG classifications were added to the end of the list. In version 25, gaps within the numbering system allow for modifications over time. They also placed new MS-DRGs in the same body system closer together in the numerical sequence.

The sequencing looks like this:

  • major complication/comorbidity (MCC);
  • complication/comorbidity (CC);
  • noncomplication/comorbidity (non-CC).

These levels are calculated based on clinical factors that aligned the new DRG system with the clinical status of the patient. They include the patient’s secondary diagnosis codes (such as pneumonia or sepsis) along with the primary diagnosis (hip fracture). The prospective payment before the MS-DRGs was driven by the resources and length of stay of the DRG rather than on the diseases or specifics associated with the patient. CMS noted this DRG system would provide more clinical relevance by aligning the diagnoses and patients with the DRG rather than resource consumption or length of stay.

There is a relationship between the relative weights and the patient’s complexity as it relates to complications and comorbidities. As these are added in, the relative weight increases, which also increases reimbursement. The expected lengths of stay also rise or fall. These tiers demonstrate the clinical severity associated with the care of these patients and allows for differences in complexity of care in the amount of reimbursement.

Observation Status

Medicare has used a reimbursement structure for observation status for decades. Some states chose to use this level of payment while others did not. The notion of observation always has been to allow providers additional time to decide whether to admit a patient. This was to be decided based on the patient’s condition and the provider’s clinical judgment as to the patient’s further needs. CMS defines observation status in this way:

“A well-defined set of specific, clinically appropriate services, which include treatment, assessment, and reassessment before a decision can be made regarding whether patients will require further treatment as hospital inpatients or if they are able to be discharged from the hospital. In the majority of cases, the decision can be made in less than 48 hours, usually in less than 24 hours. In only rare and exceptional cases do outpatient observation services span more than 48 hours.” (More information is available at this link:

Observation is considered outpatient care and is billed as such under Medicare Part B. If patients are billed as observation patients, they might have to pay a deductible (if not already met) as well as a 20% copay. If many medications are administered during the period of observation, the copay can be highly variable and place a great financial burden on the patient.

The Two-Midnight Rule

The Two-Midnight Rule took effect Oct. 1, 2013. Despite backlash from the healthcare industry and efforts to stop the rule, CMS enacted it with the 2014 Hospital Inpatient Prospective Payment System (IPPS) Final Rules. CMS scrutinized one- and two-day hospital stays for years, but few in the industry saw this rule coming. It was a game-changer for case management and all hospitals reimbursed under the IPPS. The rule affects the use of observation status, the definition of medical necessity and inpatient status, length of stay, and physician documentaion. It requires case managers to conduct due diligence at the hospital’s points of entry, particularly the emergency department (ED).

Defining 24 Hours

In the past, CMS defined 24 hours as the amount of time the patient might have needed hospital care. The Two-Midnight Rule uses different logic. Known as the Medicare Utilization Day (MUD), CMS redefined the 24-hour benchmark process. It is defined as the 24 hours starting at midnight of the first calendar day a patient is in a bed, and continues until the following midnight. While CMS states this still is a 24-hour benchmark, it adds: “the relevant 24 hours are those encompassed by two midnights.” (More information is available at: This MUD could last up to 48 hours when patients are admitted just after the first midnight benchmark.

The rule requires a patient to be admitted as an inpatient when a physician expects a patient’s hospital stay will span at least two midnights. The time the patient spends receiving treatment in the ED and/or the time that patient spends in surgery is counted as part of this period. The patient’s time of presentation can affect whether he or she is admitted. The physician must admit the patient based on a reasonable expectation that the patient’s stay will span two midnights.

Outpatient and Observation Status

The Two-Midnight Rule also clarifies what does not constitute an inpatient stay. It stipulates that diagnostic tests, surgical procedures that require a limited stay and do not span two midnights are not appropriate for inpatient admission.

Providers’ notion of observation status changes with this new rule. Physicians used observation as additional time to follow a patient’s care in the ED to determine if the patient needed to be admitted to the hospital. The rule now instructs hospitals to place any patient whose stay will not span two midnights into observation status. Once the physician gathers more information, the patient may be admitted or discharged.

This distinction between the previous use of observation and the 2014 use of observation warrants further explanation. In the 2014 use of observation status, inpatient vs. observation status was based strictly on anticipated duration of care — not the patient’s level of care. According to CMS, even a patient requiring care in a critical care bed or telemetry, but whose stay will not span at least two midnights, should be placed in observation. Most patient stays shorter than two midnights generally are not appropriate for an inpatient admission, with the exceptions of transfer, death, unforeseen recovery, leaving against medical advice, and election of hospice care. The hospital can bill the stay as an inpatient admission if patients fall into any of those categories.

A patient may be admitted under extremely limited circumstances even if the stay is not expected to span two midnights. These include: new onset mechanical ventilation (not including surgical intubation), medically necessary procedures on the inpatient-only list, and others approved by CMS.

Physician Documentation

The Two-Midnight Rule also introduced changes to physician documentation requirements. The rule requires every inpatient admission to be certified by the physician of record. Certification occurs with a valid order for admission authenticated before discharge and in compliance with the Two-Midnight Rule. The medical record also must include a history and physical examination describing diagnosis and treatment plans for the patient. It also must include a discharge plan at the time of discharge. The physician also should be sure to document complex factors such as comorbidities, severity of symptoms, current medical needs, and the risk of adverse events.

Case managers must discuss the discharge plan with the physician of record. They also should ensure agreement with the discharge plan is clearly documented in the medical record by the physician of record. CMS does not require a certification form, although some hospitals use a form or template in their electronic medical record. It is up to the hospital whether to use a form or depend on the physician’s documentation in the medical record.


In the March issue of Case Management Insider, we will continue our discussion on reimbursement by reviewing reimbursement in settings beyond acute care.