OBJECTIVE: To determine first whether higher funding of Tribally Operated Health Programs (TOHP) is associated with reduced hospitalizations for ambulatory care sensitive conditions (HASC) of the American Indian/Alaska Natives (AIAN) who use them after adjusting for characteristics of TOHP service areas; and then whether improved ambulatory care with higher levels of funding mediates the association. RESEARCH DESIGN: Records in the Indian Health Service (IHS) for California of an annual average 42,153 AIAN users of TOHP from 1998 to 2002 were linked with state hospital discharge records. We analyzed 3181 HASC for AIAN users of 20 TOHP in multilevel Poisson regression models to determine the association of HASC rates adjusted for individual age and gender with the Federal Disparity Index for IHS funding of TOHP. RESULTS: Higher IHS funding of TOHP was associated with lower HASC rates for the AIAN who use them. For TOHP with less than 60% of health care costs funded, the HASC rate dropped 12% for every increase of 10% in funding. Even adjusting for characteristics of the service areas, the effect was only slightly reduced to a value of 9% to 11%. None of the available indicators of ambulatory care tested were found to mediate the effects. CONCLUSIONS: Our findings are consistent with a policy of IHS funding of all TOHP at a level of at least 60% of the health care costs of the AIAN who use the programs, instead of the current policy of 40%. Additional research is needed to understand what ambulatory care characteristics are improved by the funding.