Psychiatric hospitals and clinics are exempted from the Medicare prospective payment system. In this paper we examine the appropriateness of the DRG classification system for psychiatric patients and argue that, using this system as the basis of payment, two types of problems are likely to arise. We categorize these problems as “risks to hospitals” and “risks to patients” and examine the existing literature to determine whether these risks are likely to be significant. We propose a different approach to paying prospectively for psychiatric care, and suggest modifications that could be made to the structure of PPS to mitigate negative incentives embedded in the current system. Although the main focus of the paper is on the unit of payment, we also make some observations about issues arising in connection with the level of payment.