How Healthcare Works: How Your Hospital Stay Gets Billed

by Abby Newberry

If you’ve been hospitalized in the United States, you have likely received multiple documents outlining how much money you are likely to or actually owe for the stay.  Have you ever wondered where that amount comes from and who decides what the hospitalization will cost?

In this article, we will take a broad overview of how your hospital diagnosis and treatment get translated into dollars.

A Bit of Background

Prior to the 1980s, hospitals calculated bills using a Retrospective Cost-Based model.  This meant that the cost of each individual component of a hospital stay, from room and board to surgeries to bandages, was tallied up after the patient was discharged home.  The hospital then submitted this total to the insurer or patient for payment.

Unfortunately, this model contributed to ballooning healthcare costs and resulted in unpredictable expenses for patients and hospitals alike.

In 1983, Medicare adopted a Prospective Payment System, in which they agreed to pay a fixed, pre-determined rate for a hospital stay based on a code called a DRG.  With Medicare setting the standard, private insurance companies soon followed suit.

What is a DRG and how does it work?

The acronym DRG stands for Diagnosis-Related Group.  The DRG is a 3-digit code that broadly describes the reason a patient is hospitalized.  It represents several factors that influence the length of the hospital stay and the required level of care.  These factors include:

• Principal Diagnosis (PDX) - the main illness or problem that prompted the hospitalization

• Procedures or surgeries performed during the hospitalization

• Co-morbidities - additional chronic or acute conditions that require evaluation or treatment during the hospital stay and that increase the complexity of care

• Complications - adverse effects resulting from existing co-morbidities or treatments provided during hospitalization

• Other elements such as the patient’s age and sex

The expected payment and length-of-stay associated with each DRG are calculated based on worldwide averages for each disease represented. 

Each year, the Center for Medicare and Medicaid Services (CMS) updates the pre-determined amount of money paid to hospitals for each DRG.  CMS determines these amounts based on current medical trends and both local and national economic conditions.  Private insurance companies make similar yearly adjustments to their DRG payments.

If the total cost of resources used during the hospitalization is less than the amount agreed upon for the specific DRG, the hospital profits by the leftover sum.  If the actual cost of care is higher than the DRG specified, the hospital loses money.  

It All Starts With A Diagnosis

The DRG for each hospital stay is assigned based on a combination of several factors, but the most important is the Principal Diagnosis (PDx).  In other words, what brought the patient to the hospital in the first place?

Each of the factors mentioned above (PDx, procedures, etc.) is, itself, represented by a diagnosis or procedure code, known as an ICD code, and composed of between 3 and 7 letters and numbers.  Each code represents one specific description of a disease or treatment, and the meaning of the code is understood in the same way by all hospitals and medical providers.

For example, the ICD code for Chronic Systolic Congestive Heart Failure is i50.22.  The code for Type 2 Diabetes is E11.9.  There are also codes that denote a combination of related diseases, such as E11.22 for Type 2 Diabetes with Chronic Kidney Disease.  Every medical facility can look up the code i50.22 and get the exact same disease description.

With the help of special software, medical coders and clinical documentation professionals comb through all the records associated with a patient’s hospital stay, from doctor and nurse notes to labs and vital signs.  Based on this documentation in the record, ICD-10 codes are assigned to a patient’s chart in descending order from most resource-intensive to least. 

 If any particular details in the documentation are unclear, coders or clinical documentation specialists will query the medical provider to clarify.  This ensures that the most appropriate ICD codes are assigned.

The diagnoses and procedures that required the most attention and resources during the hospitalization are listed at the top.  This list of ICD codes is analyzed according to a standardized set of coding rules.  The final result of this calculation is the DRG.  In the current healthcare environment, this calculation is typically performed by software that implements the necessary coding rules and algorithms.

A Deeper Dive Into Understanding ICD Codes

ICD codes are part of the International Classification of Diseases, which is a standardized medical data system developed and maintained by experts from the World Health Organization.  Each country then modifies this list slightly to meet the needs of its own national health system.  

This collection of codes is refined and updated every few years to reflect changes in medical knowledge and new technologies.  ICD is currently in its tenth version, denoted by the abbreviation ICD-10.  The rules for using the codes are updated once a quarter, and as of 2026 there are around 75,000 ICD codes!

ICD codes are recognized worldwide, which means the information in a patient’s chart is less likely to get “lost in translation” due to differences in language, abbreviations, and terminology.  They also help describe a patient’s conditions and procedures as precisely and accurately as possible by clarifying details such as acuity (severity) and laterality (right or left). 

In addition to ensuring consistency in capturing data for billing, the codes utilized under ICD can provide valuable information for medical research and tracking global health trends.

Final Billing Stages

Once all the appropriate codes are listed and the DRG is assigned, the chart is sent for final billing.  The billing department verifies insurance coverage and sends a claim to the appropriate payor (Medicare, private insurance, etc.).  The payor will adjudicate the claim, meaning they will seek more information if they feel the coding or documentation is incomplete.  

When the payer is satisfied that it has all the correct information, it will either deny the claim or pay the hospital some or all of the requested amount.  The hospital may dispute a claim denial and return it to the insurer for reconsideration if the denial is deemed unfair or in error.  

Finally, the insurer pays the hospital the agreed amount.  If there is still an outstanding balance, the hospital will send an invoice to the patient requesting payment.  Once the claim is fully paid, the billing cycle for the hospitalization is complete.

References

CareSet. (2025, August 17). Understanding DRG Medical Definition, History and Impact. Retrieved December 30, 2025 from https://careset.com/understanding-drg-medical-definition-history-and-impact/#:~:text=Explore%20the%20History%20and%20Evolution,in%20medical%20practices%20and%20technologies

Centers for Medicare & Medicaid Services. (n.d.). Design and Development of the Diagnosis Related Group (DRGs). Retrieved January 4, 2026 from https://www.cms.gov/icd10m/version37-fullcode-cms/fullcode_cms/Design_and_development_of_the_Diagnosis_Related_Group_(DRGs).pdf

Gaboury, M.  (2025, September 8). Reviewing FY 2026 coding updates. Healthcare Provider Solutions.  Retrieved January 4, 2026 from https://healthcareprovidersolutions.com/reviewing-fy-2026-coding-updates/

Hitch, J. (2024, June 11). Understanding DRG Codes And Their Impact on Hospitals. EvidenceCare.  Retrieved December 30, 2025 from https://evidence.care/understanding-drg-codes-and-their-impact-on-hospitals/#:~:text=The%20origin%20of%20the%20DRG,research%20into%20the%20real%20world

Mancuso, D. (2023, November 29).  The Evolution of Electronic Medical Claims and Revenue Cycle Management in the US Healthcare System. The SSI Group. Retrieved December 30, 2025 from https://thessigroup.com/blog/the-evolution-of-electronic-medical-claims-and-revenue-cycle-management-in-the-us-healthcare-system/

Assessed and Endorsed by the MedReport Medical Review Board