This study examines how hospitals respond to the reimbursement and monitoring methods used under the Medicare Prospective Payment System. Under the reimbursement system, hospitals can follow several strategies to increase profit. The strategies examined here are: 1) providing inaccurate reports of diagnoses, and 2) unnecessarily admitting patients. Empirical evidence supports the contention that hospitals follow these strategies and that the extent to which they do differs across diagnoses. The results have implications for the form of monitoring done under the Prospective Payment System.