We compared patient outcomes before and after the introduction of the diagnosis related groups (DRG)-based prospective payment system (PPS) in a nationally representative sample of 14,012 Medicare patients hospitalized in 1981 through 1982 and 1985 through 1986 with one of five diseases. For the five diseases combined; length of stay dropped 24% and in-hospital mortality declined from 16.1% to 12.6% after the PPS was introduced (P less than .05). Thirty-day mortality adjusted for sickness at admission was 1.1% lower than before (16.5% pre-PPS, 15.4% post-PPS; P less than .05), and 180-day adjusted mortality was essentially unchanged at 29.6% pre-vs 29.0% post-PPS (P less than .05). For patients admitted to the hospital from home, 4% more patients were not discharged home post-PPS than pre-PPS (P less than .05), and an additional 1% of patients had prolonged nursing home stays (P less than .05). The introduction of the PPS was not associated with a worsening of outcome for hospitalized Medicare patients. However, because our post-PPS data are from 1985 and 1986, we recommend that clinical monitoring be maintained to ensure that changes in prospective payment do not negatively affect patient outcome.