A social experiment was conducted in San Diego to test the effectiveness of monetary incentives in improving the health of nursing home residents and lowering Medicaid expenditures. Use of a Markov model to represent the resulting health changes of nursing home residents shows that the monetary incentives had beneficial effects on both the quality and the cost of nursing home care. Moreover, the nursing homes admitted more people with severe disabilities, and the average length of their stays was shortened. If implemented, this kind of incentive program would save Medicaid substantial amounts of money, but not through lowering nursing home payments. Instead, the more efficient use of nursing homes would transfer more people out of hospitals and thereby save unnecessary hospital reimbursement.