In an effort to control the increase in health care expenditures, while at the same time improving or at least maintaining access to hospital services, several states enacted prospective hospital rate-setting systems in the 1970s and early 1980s. This report evaluates New Jersey's system, which was unique because it elected to pay hospitals on the basis of the then newly created case-mix classification system, diagnosis-related groups (DRGs). The authors evaluate New Jersey's hospital rate-setting system and analyze the responses of hospitals in the early years of the program. Their analysis show that the New Jersey all-payor DRG rate-setting system has been successful in improving intermediate measures of hospital efficiency but unsuccessful in controlling hospital cost inflation, measured in terms of either total hospital expenses or net revenues. The findings also show that Medicare patients consume more resources than privately insured patients, but because of the structure of the rate-setting methodology and other features of the New Jersey system, differences in profitability between Medicare and non-Medicare patients were not as great as differences in resource use.