The author presents an optimization model of a nursing home that incorporates the following characteristics: proprietary profit maximization, the distinction between private and Medicaid patients, nonessential expenditure aimed at market identification, and cost-based government reimbursement. The model is used to analyze the effect of changes in government reimbursement. The theoretical analysis indicates that increases in government reimbursement need not lead to increases in nonessential cost expenditures and private patient charges; in fact, the contrary may result. The econometric analysis suggests empirical support for the latter. Higher reimbursement factors are associated with lower charges. Copyright 1989 by The Review of Economic Studies Limited.