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BACKGROUND: The Balanced Budget Act of 1997 dramatically changed the way that Medicare pays skilled nursing facilities and also cut per-diem rates. Previous studies have found effects on facility-wide staffing but not on quality for short-stay residents. Because facilities may combine revenue streams to be used where needed, spillover effects on quality of care for long-stay residents are possible. OBJECTIVE: We sought to investigate effects of financial pressures from Medicare payment changes on quality of care for long-stay residents. METHODS: We investigated the effect of Medicare's Prospective Payment System for skilled nursing facilities on incidence of urinary tract infections and pressure sores among long-stay residents while controlling for resident severity. We conducted panel data analysis of nursing home residents in Ohio, Kansas, Maine, Mississippi, and South Dakota using Minimum Data Set data from 1995 to 2000. Each facility's Medicare dependence was used to separate effects of the policy from underlying industry trends. RESULTS: The probability of developing a urinary tract infection or pressure sore increased significantly among long-stay residents after Medicare's prospective payment system was implemented. Effects were roughly proportional to the percent of residents in a facility covered by Medicare. CONCLUSIONS: Although Medicare prospective payment and rate cuts were directly applicable only to Medicare (largely short-stay) residents in skilled nursing facilities, the resulting financial pressures lowered the quality of care experienced by long-stay residents, as measured by the likelihood of adverse outcomes. The observed quality decreases were likely due to decreases in nurse staffing prompted by the payment reductions. [ABSTRACT FROM AUTHOR]