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<.05). Thirty-day mortality adjusted for sickness at admission was 1.1% lower than before (16.5% pre-PPS, 15.4% post-PPS; P<.05), and 180-day adjusted mortality was essentially unchanged at 29.6% pre- vs 29.0% post-PPS (P<.05). For patients admitted to the hospital from home, 4% more patients were not discharged home post-PPS than pre-PPS (P<.05), and an additional 1% of patients had prolonged nursing home stays (P<.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.