Medicare's prospective payment system for hospitals is this administration's response to the rapid growth in hospital costs, which, under the old system of retrospective payment, have increased at an average annual rate of 17.5% since 1979. In 1982, hospital costs accounted for roughly two thirds of the $50.9 billion expended for Medicare. This amounted to more than $3 billion per month paid out to hospitals in 1982, in contrast to the first full year of Medicare, 1967, in which all Medicare outlays amounted to only $3.4 billion. During 1982, hospital expenditures increased 12.6%—three times the general rate of inflation. Solvency of the Medicare trust fund rests, in part, on the success of the prospective payment system.
The foundation of the system is the diagnosis-related groups (DRGs), which have been established for all hospitals participating in the program. The 468 established DRGs cover specific procedures ranging from cholecystectomies to the treatment
Davis CK. The Impact of Prospective Payment on Clinical Research. JAMA. 1985;253(5):686-687. doi:10.1001/jama.1985.03350290092034