The Health Care Financing Administration (HCFA) is currently developing a prospective payment system (PPS) for skilled nursing facilities. This system is to be implemented for cost reporting periods beginning on or after July 1, 1998. We have reviewed HCFA's methodology for developing the new system and believe it will result in PPS rates that are inflated. The HCFA did not adjust base year costs (Fiscal Year 1995) for medically unnecessary care and/or the amount of improper payments that were made to skilled nursing facilities. If improper payments are not eliminated from the base period costs, unwarranted financial windfalls will be realized by skilled nursing providers. Consequently, we are recommending that HCFA include a provision in the interim final rule that indicates these proposed rates will be further reviewed and adjusted downward to reflect the amount of improper payments in the base year costs.