The Health Care Financing Administration (HCFA) plans to implement a prospective payment system (PPS) for outpatient department (OPD) services in the Year 2000. We reviewed HCFA's methodology for establishing fee schedules under the new system and concluded HCFA's methodology will cause the fee schedules to be inflated. The HCFA's methodology does not adequately adjusts for factors such as unallowable costs and improper payments which were included in the base period when calculating the fee schedule amounts and targeted expenditure ceiling. Hospitals will realize windfall profits at Medicare's expense if these factors are not taken into account. Also, OPD reimbursements are inflated in comparison to amounts paid for similar services performed in other settings, such as ambulatory surgical centers and physicians' offices. We are recommending that other studies be made to assess the extent to which unallowable costs and improper payments were included in base period costs, and that appropriate adjustments be made to the fee schedules and expenditure ceiling. We are also recommending that HCFA carefully consider the potential efficiencies demonstrated in various service settings when establishing uniform payment rates. The HCFA concurred with our recommendations.