To assess the impact of Medicare's prospective payment system (PPS) on nursing homes, we reviewed hospitalization and mortality data for Wisconsin's Medicaid and general elderly populations. During the 12 months following implementation of the PPS, Wisconsin's institutionalized elderly Medicaid population experienced a 72% increase in the rate of hospitalization and a 26% decline in hospital length of stay. Two explanations for the increased hospitalization include physician manipulation of the PPS and increased rehospitalization of nursing home residents who may have been discharged prematurely from hospitals. Between 1982 and 1985, analysis of mortality data revealed a 26.2% increase in the rate of deaths occurring in nursing homes. The increase in nursing home deaths began in 1983 and was associated with a 10.3% decline in hospital deaths during the same period. Using a series of logistic analyses, the shift in location of death from hospitals to nursing homes was found to be more pronounced after implementation of the PPS. This change in location of death may reflect both a less aggressive use of hospital resources by physicians caring for terminally ill patients and a transfer of seriously ill patients to nursing homes for terminal care.