Objectives We aimed to validate an algorithm using both primary discharge diagnosis (International Classification of Diseases Ninth Revision (ICD-9)) and diagnosis-related group (DRG) codes to identify hospitalisations due to decompensated heart failure (HF) in a population of patients with diabetes within the Veterans Health Administration (VHA) system. Design Validation study. Setting Veterans Health Administration-Tennessee Valley Healthcare System Participants We identified and reviewed a stratified, random sample of hospitalisations between 2001 and 2012 within a single VHA healthcare system of adults who received regular VHA care and were initiated on an antidiabetic medication between 2001 and 2008. We sampled 500 hospitalisations; 400 hospitalisations that fulfilled algorithm criteria, 100 that did not. Of these, 497 had adequate information for inclusion. The mean patient age was 66.1 years (SD 11.4). Majority of patients were male (98.8%); 75% were white and 20% were black. Primary and secondary outcome measures To determine if a hospitalisation was due to HF, we performed chart abstraction using Framingham criteria as the referent standard. We calculated the positive predictive value (PPV), negative predictive value (NPV), sensitivity and specificity for the overall algorithm and each component (primary diagnosis code (ICD-9), DRG code or both). Results The algorithm had a PPV of 89.7% (95% CI 86.8 to 92.7), NPV of 93.9% (89.1 to 98.6), sensitivity of 45.1% (25.1 to 65.1) and specificity of 99.4% (99.2 to 99.6). The PPV was highest for hospitalisations that fulfilled both the ICD-9 and DRG algorithm criteria (92.1% (89.1 to 95.1)) and lowest for hospitalisations that fulfilled only DRG algorithm criteria (62.5% (28.4 to 96.6)). Conclusions Our algorithm, which included primary discharge diagnosis and DRG codes, demonstrated excellent PPV for identification of hospitalisations due to decompensated HF among patients with diabetes in the VHA system.