Pursuant to a legislative requirement, GAO: (1) examined the factors responsible for the variations in patient costs and Medicare payments among teaching and nonteaching hospitals; and (2) estimated the adjustment needed to compensate teaching hospitals for the indirect cost of medical education. GAO found that: (1) teaching hospitals had higher patient-care costs than nonteaching hospitals because of costlier locations and case mixes and because they tended to be larger than nonteaching hospitals; (2) location, case mix, hospital size, and the availability of a graduate medical education program are contributory factors to variations in Medicare payments to hospitals; and (3) the Prospective Payment System (PPS) formula created an imbalance in Medicare payments because it did not account for all cost variation sources. GAO estimated that an appropriate indirect-cost adjustment factor would be: (1) 3.73 percent if the PPS formula were expanded to include other relevant cost factors; (2) 5.9 percent under the PPS formula; and (3) 6.26 percent, taking into account the shortcomings in the PPS formula and PPS failure to consider other cost factors in the indirect-teaching-cost adjustments. GAO believes that an adjustment factor of 6.06 percent would be appropriate after 1995.