The authors examined how the Medicaid hospital benefit structure affects the length of stay of psychiatric inpatients and transfers to state mental hospitals and nursing homes. They hypothesized that length-of-stay and discharge patterns would depend on five classes of variables: patient characteristics, diagnosis, mental health status, hospital characteristics, and benefit structure. Analysis of 976 Medicaid cases showed that the variables together accounted for only 17 percent of the variation in patient length of stay; benefit structure alone accounted for 6 percent of the variation, slightly less than the diagnostic variables. A patient's clinical status was the most important predictor of transfer to state mental hospitals, although benefit structure had a significant effect. It had no effect on patient transfers to nursing homes. The authors discuss the implications of the findings for designing prospective payment systems for psychiatric patients under Medicare.