Are hospitals' profits and losses consistent with Medicare's Prospective Payment System's (PPS) intent to reward efficiency and penalize inefficiency? How do hospitals respond to their different financial positions and what is the impact of their responses on quality, process, and outcomes of care? This study assessed the relationship between hospital profits (both total profit and PPS profit margins) and efficiency (defined as the lowest hospital cost for hospitals of a given size, adjusting for payer mix, quality, input prices, Medicare patient characteristics, and outcomes). Using 1987-1989 hospital and Medicare data, the project examined whether differences in profit rates are associated with changes in the proportion of Medicare cases flagged for potentially poor quality; Medicare patients' outcomes; volume and mix of both Medicare and non-Medicare patients treated and services offered; staffing levels and capital spending; average case-mix, severity level, and demographic characteristics of Medicare patients treated; and efficiency and profitability in the next year.