To determine the extent to which hospitals are reimbursed for Medicare patients who develop nosocomial pneumonia, we analyzed hospital accounting costs, reimbursements received, and the net income from 33 Medicare patients who developed nosocomial pneumonia. In 31 of the 33 cases, hospital costs for the entire admission exceeded reimbursements, with a median net loss of $5800 per case. Eleven randomly selected pneumonia cases were compared with control patients matched by diagnosis related group, age, sex, and service. Cases had significantly longer hospital stays, had greater total hospital costs, and caused greater net losses than did matched controls. We conclude that hospitals are seldom reimbursed adequately for Medicare patients who develop nosocomial pneumonia. With the advent of the prospective payment system, hospitals now have substantial financial incentives for implementing cost-effective measures for preventing nosocomial pneumonias.