DTOC: Dynamic Tool Output Compression for Adaptive Context Management in AI Agents

As agent capabilities have grown, practical limitations increasingly stem from constrained context windows rather than model capacity. Common strategies, such as truncation, heuristic aging, and lossy summarization, may discard useful information or introduce hallucination risk. To address these challenges, we propose Dynamic Tool Output Compression (DTOC), a framework for scalable context management in LLM-based agents that models context updates as explicit and reversible operations within the agent reasoning loop. DTOC retains full tool outputs in external memory while inserting compact placeholders into the active context, enabling selective reconstruction when needed. We formalize the DTOC mechanism, integrate it into a ReAct-style agent architecture, and provide a production-oriented implementation supporting on-demand restoration of compressed outputs. Experiments on DeepSWE reveal model-dependent effects: for responsive models (Sonnet 4.6, GPT-5.4), DTOC reduces input tokens (10.3 and 12.7%) and agent steps (2.4 and 32.3%), while increasing solve rates (2.5 and 1.5 times higher) and lowering cost per solved task (3 and 3.5 times lower cost per solved task). For the other models results are more mixed, with GPT-5.5 doubling solve rate and halving cost, but no impact on solve rate and negative impact on cost for the other models. Ablation results show reversibility is critical: disable-only compression variants degraded performance, while full DTOC recovered baseline accuracy at substantially lower context cost. These findings indicate that explicit, reversible context management can improve the efficiency of long-horizon agent reasoning without degrading task performance.