This paper examines the effects of the Prospective Payment System on the behavior of hospitals with respect to their capital allocations and the efficiency with which they produce in-patient care. A theoretical model adapted from Pope  yields the testable hypotheses that as a hospital's Medicare population increases the hospital will supply greater levels of capital and produce in-patient care using less technically efficient methods. A two stage test of these hypotheses is run on a sample of US non-federal hospitals. Results from patient demand functions and a stochastic profit frontier are consistent with the theoretical model. © 1996 Kluwer Academic Publishers.