In this paper, the authors examine why not-for-profit nursing homes are more costly than for-profit nursing homes in terms of managerial efficiency and quality. However, managerial efficiency and quality differences do not completely explain cost differentials. Specifically, diseconomies of scale in the production of quality imply that quality differences are translated into proportionately larger cost differentials. Using data from New York State, we find that for-profit nursing homes have approximately 15.9 percent lower costs. Almost none of the cost difference can be explained by managerial inefficiency. But not-for-profit homes do provide 3.9 percent higher quality. This relatively small quality advantage is translated into a four-fold larger cost differential because of very large diseconomies of scale in the production of quality. There may be good news and bad news in our findings for reducing health care costs. It appears that in a logical place to find managerial inefficiency, the nonprofit sector, little was found. If these results are true for the health care industry as a whole, then further cost savings can only be achieved through reductions in the quality of care provided. However, if there are large diseconomies of scale in the production of quality in general, then small quality sacrifices will produce large cost savings.