A case-mix classification system for nursing home residents is developed, based on a sample of 7,658 residents in seven states. Data included a broad assessment of resident characteristics, corresponding to items of the Minimum Data Set, and detailed measurement of nursing staff care time over a 24-hour period and therapy staff time over a 1-week period. The Resource Utilization Groups, Version III (RUG-III) system, with 44 distinct groups, achieves 55.5% variance explanation of total (nursing and therapy) per diem cost and meets goals of clinical validity and payment incentives. The mean resource use (case-mix index) of groups spans a nine-fold range. The RUG-III system improves on an earlier version not only by increasing the variance explanation (from 43%), but, more importantly, by identifying residents with "high tech" procedures (e.g., ventilators, respirators, and parenteral feeding) and those with cognitive impairments; by using better multiple activities of daily living; and by providing explicit qualifications for the Medicare nursing home benefit. RUG-III is being implemented for nursing home payment in 11 states (six as part of a federal multistate demonstration) and can be used in management, staffing level determination, and quality assurance.