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This paper examines how changes in Medicare reimbursement rates affect the degree to which physicians induce demand for Medicare services. Demand inducement is measured by analyzing changes in the intensity and quantity of services provided and the number of ancillary services ordered. The empirical work is based on data that include copies of all Medicare claims for Colorado physicians between 1976 and 1978. During that period a change in the state's Medicare reimbursement system occurred, resulting in a large increase in some physicians' reimbursement rates and a relative decrease in those of others. Using this “natural experiment,” we can determine how changes in financial incentives affect various forms of demand inducement. The study results are consistent with the theory that demand inducement exists. It appears to take several forms: provision of more highly intensive medical and surgical services, greater quantities of surgical services, and ordering of more laboratory tests.