Using 1982 data from 5732 US hospitals, we found that costs were substantially higher in hospitals operating in more competitive local environments than in hospitals in less competitive environments. After controlling for wage rates, patient case mix, state regulatory programs, and hospital teaching role, average costs per admission were found to be 26% higher in hospitals in the most competitive markets (more than ten hospitals within a 24-km radius) than in hospitals with no competitors within a 24-km radius. Average costs per patientday were 15% higher in the most competitive markets than in hospitals with no neighbors. These findings on the cost implications of nonprice competition among hospitals suggest that the new modes of hospital payment will have a greater disruptive impact on hospital behavior in areas with many, rather than few, hospitals. In anticipating the effects of new modes of payment on hospital behavior, policymakers should consider the nature of quality competition as well as price competition within local markets.