Our study estimates the sensitivity and specificity of Medicare claims to identify clinically-diagnosed dementia, and documents how errors in dementia assessment affect dementia cost estimates. We compared Medicare claims from 1993-2005 to clinical dementia assessments carried out in 2001-2003 for the Aging Demographics and Memory Study (ADAMS) cohort (n = 758) of the Health and Retirement Study. The sensitivity and specificity of Medicare claims was 0.85 and 0.89 for dementia (0.64 and 0.95 for AD). Persons with dementia cost the Medicare program (in 2003) $7,135 more than controls (P < 0.001) when using claims to identify dementia, compared to $5,684 more when using ADAMS (P < 0.001). Using Medicare claims to identify dementia results in a 110% increase in costs for those with dementia as compared to a 68% increase when using ADAMS to identify disease, net of other variables. Persons with false positive Medicare claims notations of dementia were the most expensive group of subjects ($11,294 versus $4,065, for true negatives P < 0.001). Medicare claims overcount the true prevalence of dementia, but there are both false positive and negative assessments of disease. The use of Medicare claims to identify dementia results in an overstatement of the increase in Medicare costs that are due to dementia.