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The picture below show pretty much where I am right now, category on the left & in my app I can drag items in categories & move it like that.

The issue I have right now is that an Item can be a category & I am unsure what would be the best way to handle this situation,

I'm thinking of having a settings button on hover & a way to create a category from an item.

Any other suggestions?

enter image description here

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It's not a good idea to mix two interaction types: drag and drop and button. More consistent way is to support drag and drop operation for Category creation. See the picture.
enter image description here
Pay attention:

  • New category label is a visible cue
  • placing in on the top guarantees its visibility when there are many categories
  • gray color doesn't distract and distinguish it from the existing categories
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If you use any GTD ([Getting Things Done][1]) apps, you'll see this at work in [Omnifocus][2] desktop. These are essentially list containers, like many organization apps. You can simply drag the task to the sidebar, and it becomes a project (similar to a category). Alexey is spot on with the wireframe above. [1]: en.wikipedia.org/wiki/Getting_Things_Done [2]: omnigroup.com/omnifocus –  Mike Nov 4 '13 at 19:54
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