This study compares the financial impact of a Diagnosis Related Group (DRG) prospective payment system with that of a Severity of Illness-adjusted DRG prospective payment system. The data base of about 106,000 discharges is from 15 hospitals, all of which had a Health Care Financing Administration (HCFA) DRG case mix index greater than 1. In order to pool the data over the 15 hospitals, all charges were converted to costs, normalized to Fiscal Year 1983, and adjusted for medical education and wage levels. The findings showed that, for the study population as a whole, DRGs explained 28 per cent of the variability in resource use per case while Severity of Illness-adjusted DRGs explained 61 per cent of the variability in resource use per case. When we simulated prospective payment systems based on DRGs and on Severity-adjusted DRGs, we found that the financial impact of the two systems differed by very little in some hospitals and by as much as 35 per cent of total operating costs in other hospitals. Thus, even with a data set that is relatively homogeneous (with respect to the HCFA DRG case mix index definition of hospitals), we found substantial inequities in payment when DRGs were not adjusted for Severity of Illness. These findings suggest that, with a more representative set of hospitals, the difference between unadjusted and Severity-adjusted DRG-based prospective payment could be greater than 35 per cent of a hospital's total operating costs.