OBJECTIVE: This study examined differences in the prevalence of dementia among Medicare beneficiaries by race and gender as well as racial differences in the effects of dementia on the use and costs of health care services. METHODS: Data from a 5 percent random sample of Medicare beneficiaries in the state of Tennessee who filed claims between 1991 and 1993 (N=33,680) were analyzed. Dementia was assessed on the basis of ICD-9 codes in the billing records of the Health Care Financing Administration (HCFA), along with information on gender, race, comorbid psychiatric conditions, use of health services, and the actual amounts paid by HCFA. Patients with dementia related to Alzheimer's disease were excluded. RESULTS: Diagnoses of dementia were significantly more prevalent among African-American beneficiaries than among white beneficiaries (5 percent compared with 3.9 percent). Persons with dementia had higher rates of health service use, particularly for inpatient care, and African-American persons with dementia had the highest levels of service use. Health care costs were also significantly higher for African Americans with a diagnosis of dementia. Among patients of either race, costs were substantially higher among those with comorbid psychiatric conditions. CONCLUSIONS: Racial differences in the prevalence of dementia are clearly evident. Race also plays a role in the effects of dementia on the use and costs of health services, with higher rates of expensive inpatient care among African Americans. Racial differences in both the prevalence and costs of dementia produce a considerable burden on the health care system. Addressing racial disparities in the prevalence of dementia would result in substantial cost savings.