The Northern Territory intends to make use of Australian National Diagnosis Related Groups (DRGs) and their cost relativities as the basis for the allocation of budgets among public hospitals. The study reported here attempted to assess the extent to which there are variations in severity of illness and socio-economic status which are not adequately explained by DRG alone and, if so, to develop a DRG payment adjustment index by use of routinely available data items. The investigation was undertaken by use of a database containing all discharges between July 1992 and June 1995. Hospital length of stay was used as a proxy for cost. Multivariate analysis was undertaken and it was found that several variables were associated with cost variations within DRGs. Stepwise multiple linear regression was used to develop a model in which 14 variables were able to explain 45% of the variations. Index values were subsequently computed from the regression model for each of eight categories of admitted patient episodes which are the intersections of three binary variables: Aborigine or non-Aborigine, rural or urban usual place of residence of the patient and hospital type (teaching or other). It is intended that these index values will be used to compute differential funding rates for each hospital in the Territory.