Practice costs (not including liability insurance costs) account for approximately 41% of the payment for medical and surgical services in the Medicare Fee Schedule. Unlike the portion of the fee schedule that compensates physicians for their work, the practice cost portion of the Medicare Fee Schedule is not resource-based; it is based instead on historical charges. As a result, physicians can recover their practice costs in less time and with less effort (measured in work relative value units) by performing invasive procedures and tests than by providing evaluation and management services. The Physician Payment Review Commission has proposed, in some detail, a method for incorporating practice costs into the Medicare Fee Schedule. The method involves allocating indirect costs on the basis of physician work plus direct costs. We find, using their own analytical framework, that indirect costs should rather be allocated on the basis of time. But to better serve the goal of incentive neutrality, and to make practice cost payments more equitable, the payment a physician receives for practice costs should be based not on service mix and volume, but on characteristics of the physician's practice more closely related to practice costs: for example, whether the physician has an office, or whether the physician practices alone or in a group.