OBJECTIVE: The authors examined the impact of budgeting based on diagnosis-related groups (DRGs) on inpatient psychiatric care in Department of Veterans Affairs (VA) medical centers. DRG-based budgeting was implemented by the VA in 1984 and suspended in 1988. METHOD: Computerized discharge abstracts were obtained for all episodes of VA inpatient care occurring from 1980 through 1989. The number of discharges per year, number of unduplicated patients treated, mean length of stay, total number of bed days of care per unique patient per year, readmission rates, and number of episodes of care per operational bed were determined for psychiatric and nonpsychiatric (medical- surgical) hospitalizations occurring before, during, and after DRG- based budgeting was in effect. RESULTS: In the case of VA psychiatric care, DRG-based budgeting was associated with more episodes of care, shorter lengths of stay, higher readmission rates, and more episodes of care per occupied bed. DRG-based budgeting had similar effects on medical-surgical care, although an increase in the number of episodes of care was not observed. During the first year after this funding mechanism was suspended, changes in both psychiatric and medical- surgical care that were related to DRG-based budgeting were slowed and, in some cases, reversed. CONCLUSIONS: Both psychiatric and medical- surgical inpatient care in the VA were sensitive to changes in funding mechanisms. These changes were generally similar to those observed in psychiatric care provided by non-VA hospitals reimbursed under Medicare's DRG-based prospective payment system.