BackgroundThe original version of the inpatient prospective payment system is based on a fixed payment for an episode of treating a patient with a given diagnosis. However, specialised hospitals, as well as countries with historical differences in hospital reimbursement, require a modification with per diem prospective payments. MethodsThis paper provides theoretical and empirical analysis of hospitals' volume, proxied by average length of stay, and hospitals' quality, proxied by planned readmission rate, under different reimbursement systems. We demonstrate hospitals' heterogeneity in the response to the change from the fee-for-service (FFS) to a per diem prospective payment system with a length-of-stay dependent step-down rate (SDR): hospitals with shorter (longer) average length of stay under FFS have longer (shorter) average length of stay under SDR. We show that for FFS hospitals with longer average length of stay, the planned readmission rate increases under SDR. FindingsWe use a recently released administrative database for 684 Japanese hospitals in 2007–11 (Ministry of Health, Labor, and Welfare), with most hospitals changing the financial method from FFS to SDR during this period. The data are supplemented with financial variables (Ministry of Internal Affairs), accreditation information (Japan Council for Quality Health Care), and hospital characteristics (Handbook of Hospitals). The empirical analysis is conducted for each major diagnostic category. The results of the estimations with dynamic panel data provide empirical support for the predictions of our theoretical model. InterpretationThe results suggest that SDR contributes to differential hospitals' response to a per diem prospective payment system and might lead to insufficient cost containment. The findings are relevant not only for country-level (Japan, Germany), but also for medical-specialty-level generalisations. Indeed, prospective per diem payments are currently employed in Medicare's psychiatric hospitals, skilled nursing facilities, hospices, and in Medicaid's psychiatric inpatient facilities. FundingDAS received funding from Belk College of Business Dean's grant for 2012–13.