Payers are considering bundled payments for inpatient surgery, combining provider reimbursements into a single payment for the entire episode. We found that current Medicare episode payments for certain inpatient procedures varied by 49-130 percent across hospitals sorted into five payment groups. Intentional differences in payments attributable to such factors as geography or illness severity explained much of this variation. But after adjustment for these differences, per episode payments to the highest-cost hospitals were higher than those to the lowest-cost facilities by up to $2,549 for colectomy and $7,759 for back surgery. Postdischarge care accounted for a large proportion of the variation in payments, as did discretionary physician services, which may be driven in turn by variations in surgeons' practice styles. Our study suggests that bundled payments could yield sizable savings for payers, although the effect on individual institutions will vary because hospitals that were relatively expensive for one procedure were often relatively inexpensive for others. More broadly, our data suggest that many hospitals have considerable room to improve their cost efficiency for inpatient surgery and should look for patterns of excess utilization, particularly among surgical specialties, other inpatient specialist consultations, and various types of postdischarge care.