The Chinese government began a major reform of the hospital sector in the early 1980s. The main aim was to increase productivity by phasing out prospective global budgets from the government, and encouraging between-hospital competition for the business of user-pay and insured patients. This goal was to be achieved without unreasonable prejudice to the financial sustainability of hospitals or to the fairness of access and service provision. We explored the effects of these changes by analysing data for four levels of hospital in two of the most populous provinces between 1985 and 1999. We used data envelope analysis, and found that the majority of hospitals experienced a decline in productivity. Social efficiency (measured by the level of provision of unnecessary services) also declined, especially in the largest hospitals that could easily increase the use of expensive technologies. Most hospitals increased their economic sustainability, measured as the ratio between revenue and expenditures. However, the lowest-level hospitals experienced stable or reduced sustainability due to their inability to compete with marketing by higher-level hospitals. We conclude that, although there were many benefits, the overall impact of the introduction of market forces may have been negative. An important factor was that not all aspects (such as supplier-induced demand) were adequately controlled by government agencies. We suggest ways of alleviating the most problematic elements of current arrangements.