In 1998 the Medicare program allocated $5.9 billion in graduate
medical education (GME) payments to teaching hospitals and
$4.5 billion in Medicare disproportionate share hospital (DSH)
payments to hospitals that treat a substantial number of lowincome
patients. These supplemental payments to hospitals are in
addition to the standard reimbursement payments that all hospitals
receive for providing inpatient services to Medicare beneficiaries.
The standard reimbursement amounts, known as diagnostic
related group or DRG payments, are set equal to the average cost
of treating a Medicare patient with a particular health condition.
DRG payments to all hospitals totaled $87.4 billion in 1998.
Since DRG payments are intended to cover the cost of treating
Medicare patients, the supplemental payments under the GME
and DSH programs can be viewed as subsidies to hospitals.
Supplemental reimbursements to hospitals in the form of
GME and DSH payments have grown rapidly over the last decade.
They now equal 12 percent of standard Medicare payments for
inpatient hospital care under the DRG system, up from 8.6 percent
in 1988. Since these payments are growing rapidly and are
an important source of funds for many U.S. hospitals, the original
rationale for these subsidies and their effects on hospital behavior
are worth reviewing.
Medicare's Prospective Payment System is administered
using DRG pricing formulas. Its two principal goals are (1) to
ensure that Medicare beneficiaries have access to high-quality
inpatient hospital care, and (2) to encourage hospitals to provide
these services efficiently. To foster these objectives, DRG payments
are set, as we have noted, at the average cost of treating

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