means by which these rates are calculated is explained below. In all there are 467 groups (although initially there were but 383), each with a corresponding rate. Hospitals are paid these rates regardless of the costs they incur in treating patients. They either retain the differences, or make up for the losses between the fixed DRG payments and the costs of rendering care; so a clear incentive exists for administrators to minimize costs. As a result, this system is viewed as a logical strategy for stemming the rise in hospital care costs.

Although the de

The appeal of the system has recently received recognition on the federal level through Secretary of Health and Human Services Schweiker's proposed plan to reimburse hospitals for treating Medicare patients on the basis of DRGs. tails of the proposal have yet to be unfurled, it differs from the New Jersey system in two important respects. First, while in New Jersey 100 percent of the patients are covered by the system, it will typically be the case that some 25 percent or less of the patients nationwide are covered by Medicare. Since gearing up

for the system frequently involves rather significant expenditures on data processing equipment, administrator time, generation of reports, monitoring of data quality, and, most importantly, communicating with physicians, it is not at all obvious that it will be "worth it" when only a fraction of the patients are covered. The second, and perhaps more significant difference, is that the New Jersey system requires approximately equal payment from all payers which, in turn, precludes cost shifts

between payers.

In most other states, if the approved price for

a particular kind of case paid by Medicare is below the actual

costs of caring for that case, the hospital will simply shift the unpaid costs to the commercial and self-paid business (and in some states to Blue Cross).

Thus, the incentive to reduce costs,

improve efficiency, shorten lengths of stay, etc., which are present in New Jersey will be substantially weakened elsewhere. Nevertheless, many of the lessons learned from New Jersey's experience with DRG-based reimbursement are applicable to the contemplated reimbursement program for Medicare patients, particularly if this new method of reimbursing hospitals for the treatment of such patients prompts states to adopt a comprehensive DRG reimbursement program similar to the New Jersey one.

CALCULATION OF THE DRG RATES

Prior to discussing the results of our evaluation of the New Jersey DRG system, it is appropriate to describe exactly how DRG rates are formulated. Briefly, the DRG rate-setting process begins for hospitals with the establishment of a preliminary cost base (PCB). The PCB is an estimate of the allowable annual expenses, and other financial items, for which the hospital may seek reimbursement from patients and third-party payers for the services they provide in the coming year. This estimate is derived by the New Jersey State Department of Health from previously reported (actual) hospital financial and case-mix data. For example, for the 26 hospitals that started the program in

1980, 1978 data were used to arrive at the 1980 rates. The specific financial elements included in the PCB are: direct patient care costs, indirect costs, provisions for the replacement of capital facilities, uncompensated care (i.e., bad debt and charity care), and working capital. Net income from other sources and grants for the medically indigent are later deducted.

The calculation of the direct care costs component of the PCB is relatively complex. By far, the bulk of these costs are attributable to treating inpatients who, as noted above, are assigned to DRGs. The process of determining the direct patient care costs from the current year's cost base (again, for developing the 1980 PCB, 1978 was the "current" year), relies on various "measures of resource use" (MRUs). Given the problems associated with determining the true cost of treatment, MRUS serve as proxies for actual resource consumption. For instance, patient days are presently used to estimate nursing costs, the assumption being that equal amounts of nursing resources are consumed daily regardless of diagnosis, age, or other factors. [1]

MRUS can therefore be used to indicate the cost of services supplied by hospital cost centers to each DRG, and ultimately DRG rates per case. This is accomplished by first computing the ratio of MRUS consumed by all patients within a given DRG to the total number of MRUS provided by the cost center. ratio is multiplied by the total cost of operating the center in question to obtain the total cost associated with caring for patients in the DRG. The result is then divided by the number of

Next, the

patients in the DRG to arrive at the cost per case.

Suppose, for example, 200 patients assigned to DRG #243 use

a total of 1,000 of the 100,000 days of care provided by nurses in delivering routine services (e.g., medical/surgical,

pediatric, obstetrical-gynecological, etc.). If we further

assume that the total cost of the routine services cost center is $1,000,000, then the total cost of nursing care for DRG #243 (a) and the cost per case (b) can be calculated as follows:

The resulting figure is later added to the cost per case of providing ancillary services (computed in a similar manner as nursing costs except charges, as opposed to days, are used to apportion costs) to arrive at the hospital's total cost per case for DRG #243.

Once the hospital's direct patient care cost per case is determined through the cost finding procedure outlined above, direct care reimbursement rates can be calculated. To accomplish this, the hospital's cost per case must be combined with two additional factors the hospital-based physician services costs

and a standard non-physician direct care cost which represents the average non-physician cost for all of the hospitals under the system (calculated separately for teaching and non-teaching hospitals and adjusted for differences in intra-state labor costs).

These three components are depicted in Equation I below.

The share of the hospital's own cost used, and that of the standard cost, depends upon the degree of variation in the amounts of resources used in treating different patients within a DRG. If, for example, they differ substantially, then greater reliance is placed on the hospital's cost.

After the DRG payment rates are set, they are multiplied by the expected number of cases to reach the reimbursable direct patient care costs which are added to other costs (such as overhead, mixed direct/indirect, etc.) to get the hospital's total reimbursable costs. A proposed rate schedule is then submitted by the State Department of Health to the hospital and the State's Hospital Rate Setting Commission. If the hospital chooses to

reject the proposed rates, then an appeals process begins and the discrepancies are worked out.