When Congress directed that Medicare develop a prospective payment system for acute hospital care in 1983, rehabilitation hospitals were exempted. The exemption arose from a concern that the patient classification system and payment approach developed for acute care hospitals would be inappropriate for inpatient rehabilitative care. Rehabilitative care emphasizes the treatment of functional limitation and disabilities, and it usually follows a period of acute or surgical care. In contrast, acute hospital care emphasizes the stabilization of the acute problem. Consequently, one issue concerns the desirability of basing payment for rehabilitative care on diagnosis instead of some measure of functional status. A more fundamental issue is whether a separate payment system for rehabilitation is desirable given that rehabilitation typically follows acute hospital care. A major purpose of this report is to evaluate the hypothesis that functional status, rather than diagnosis, determines the costs of a rehabilitative stay and to identify other sources of differences in costs.