BACKGROUND: Angiotensin-converting enzyme (ACE) inhibitors slow renal disease progression and reduce cardiac morbidity and mortality in patients with diabetes. Patients' out-of-pocket costs pose a barrier to using this effective therapy. OBJECTIVE: To estimate the cost-effectiveness to Medicare of first-dollar coverage (no cost sharing) of ACE inhibitors for beneficiaries with diabetes. DESIGN: Markov model with costs and benefits discounted at 3%. DATA SOURCES: Published literature and Medicare claims data. TARGET POPULATION: 65-year-old Medicare beneficiary with diabetes. TIME HORIZON: Lifetime. PERSPECTIVE: Medicare and societal. INTERVENTIONS: We evaluated Medicare first-dollar coverage of ACE inhibitors compared with current practice (no coverage) and the new Medicare drug benefit. OUTCOME MEASURES: Costs (2003 U.S. dollars), quality-adjusted life-years (QALYs), life-years, and incremental cost-effectiveness. RESULTS OF BASE-CASE ANALYSIS: Compared with current practice, first-dollar coverage of ACE inhibitors saved both lives and money (0.23 QALYs gained and 1606 USD saved per Medicare beneficiary). Compared with the new Medicare drug benefit, first-dollar coverage remained a dominant strategy (0.15 QALYs gained, 922 USD saved). RESULTS OF SENSITIVITY ANALYSIS: Results were most sensitive to our estimate of increase in ACE inhibitor use; however, if ACE inhibitor use increased by only 7.2% (from 40% to 47.2%), first-dollar coverage would remain life-saving at no net cost to Medicare. In analyses conducted from the societal perspective, benefits were similar and cost savings were larger. LIMITATIONS: Results depend on accuracy of the underlying data and assumptions. The effect of more generous drug coverage on medication adherence is uncertain. CONCLUSIONS: Medicare first-dollar coverage of ACE inhibitors for beneficiaries with diabetes appears to extend life and reduce Medicare program costs. A reduction in program costs may result in more money to spend on other health care needs of the elderly.