Beginning October 1, 1983, Medicare began reimbursing many hospitals on the basis of a set of fixed fees tied to Diagnosis-Related Groups (DRGs). Using 1979-1981 Maryland data for Medicare patients, this paper compares the DRG system with the Disease Staging patient classification system in terms of structure, explanation of resource consumption (length of stay) of hospital patients, and impact on reimbursement by type of hospital. The two systems are conceptually and empirically different in classifying patients. Further, Disease Staging and DRGs perform similarly in explaining length-of-stay variation among Maryland patients. However, the two systems generate substantially different reimbursements by type of hospital. Surprisingly, large hospitals (including urban, not-for-profit, teaching hospitals) fare better under a DRG-based reimbursement system than under Disease Staging, a severity-of-illness system that excludes procedures as a basis of classification. These results imply that reimbursement policy based on Disease Staging would create disincentives to perform surgery compared with the current DRGs.