OBJECTIVES: To determine whether hospital costs are higher in patients with lower functional status at admission, defined as dependence in one or more activities of daily living (ADLs), after adjustment for Medicare Diagnosis-Related Group (DRG) payments. DESIGN: Prospective study. SETTING: General medical service at a teaching hospital. PARTICIPANTS: One thousand six hundred twelve patients aged 70 and older. MEASUREMENTS: The hospital cost of care for each patient was determined using a cost management information system, which allocates all hospital costs to individual patients. RESULTS: Hospital costs were higher in patients dependent in ADLs on admission than in patients independent in ADLs on admission ($5,300 vs $4,060, P<.01). Mean hospital costs remained higher in ADL-dependent patients than in ADL-independent patients in an analysis that adjusted for DRG weight ($5,240 vs $4,140, P<.01), and in multivariate analyses adjusting for age, race, sex, Charlson comorbidity score, acute physiology and chronic health evaluation score, and admission from a nursing home as well as for DRG weight ($5,200 vs $4,220, P<.01). This difference represents a 23% (95% confidence interval= 15-32%) higher cost to take care of older dependent patients. CONCLUSION: Hospital cost is higher in patients with worse ADL function, even after adjusting for DRG payments. If this finding is true in other hospitals, DRG-based payments provide hospitals a financial incentive to avoid patients dependent in ADLs and disadvantage hospitals with more patients dependent in ADLs.