Medicare provided teaching hospitals with US$ 5.9 billion in supplemental graduate medical education (GME) payments in 1998. These payments distort input and output prices and provide teaching hospitals with incentives to hire residents, close beds, and admit more Medicare patients. The structure of the GME payment policy creates substantial variation in input and output prices between teaching hospitals. We examine the extent to which hospitals responded to these financial incentives using a panel data set of 3,900 hospitals, including over 900 teaching hospitals. We find that teaching hospitals did hire residents and close beds in response to the Medicare policy, but did not increase Medicare admissions or alter their use of registered nurses (RNs).