Specialty hospitals, particularly those specializing in surgery and owned by physicians, have generated a relatively high degree of policy attention over the past several years. The main focus of policy debates has been in two areas: the extent to which specialty hospitals might compete unfairly with incumbent general hospitals and the extent to which physician ownership might be associated with higher usage. Largely absent from the debates, however, has been a discussion of the basic economic model of specialty hospitals. This article reviews existing literature, reports, and findings from site visits to explore the economic rationale for specialty hospitals. The discussion focuses on six factors associated with specialization: consumer demand, procedural operating margins, clinical efficiencies, procedural economies of scale, economies (and diseconomies) of scope, and competencies and learning. A better understanding of the economics of specialization will help policy makers evaluate the full spectrum of advantages and disadvantages of specialty hospitals.