Nonresponsiveness, Severity Auditing, and Upcoding Deterrence

In many countries, the diagnosis-related group system has been expanded to address patient severity. This paper highlights a fundamental drawback of any price refinement policy under adverse selection. Without auditing, no mechanism such that high-severity patients receive more intensive treatment than low-severity patients can ensure that providers are deterred from upcoding. In contrast, we show that splitting can be implemented if the regulator designs an auditing mechanism when the proportion of low-severity patients is sufficiently high. The optimal level of services increases with severity under conditions depending on the net social benefit function and on the cost function.