OBJECTIVE: Our objectives were to 1) estimate the prevalence of diabetes and diabetic lower-extremity ulcers in the Medicare population, 2) characterize Medicare population-specific costs for lower-extremity ulcer episodes, and 3) evaluate potential cost savings associated with better healing of lower-extremity ulcers. RESEARCH DESIGN AND METHODS: Prevalence and costs of diabetic lower-extremity ulcers were obtained by an analysis of Medicare claims data from 1995 and 1996 Standard Analytic Files (5% sample). RESULTS: Medicare expenditures for lower-extremity ulcer patients were on average 3 times higher than those for Medicare patients in general ($15,309 vs. $5,226). Lower-extremity ulcer-related spending accounted for 24% of total spending for lower-extremity ulcer patients. Most of the ulcer-related costs accrued on the inpatient side (73.7%); proportionately smaller amounts went to physicians and nursing home facilities. To determine the potential effect of better diabetic ulcer management, a model was created that estimated the impact on costs with improved healing rates. Improving the 20-week healing rate from 31 to 40% would save Medicare $189 per episode. CONCLUSIONS: Lower-extremity ulcers cost the Medicare system $1.5 billion in 1995. Any wound care intervention that could prevent even a small percentage of wounds from progressing to the stage at which inpatient care is required may have a favorable cost effect on the Medicare system.