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OBJECTIVE: To examine the cost-effectiveness of community-based mental health care. DATA SOURCES/STUDY SETTING: Administrative data from Medicaid and the Massachusetts Department of Mental Health; primary data from 144 psychiatrically disabled adult Medicaid beneficiaries who lived in Boston, central Massachusetts, and western Massachusetts. STUDY DESIGN: A cross-sectional observational study compared the costs and outcomes of treatment in three different types of public mental health service systems. DATA COLLECTION/EXTRACTION METHODS: Beneficiaries, randomly sampled from outpatient mental health programs, were interviewed about their mental health status. All their acute treatment and long-term continuing care for the preceding year were abstracted from Medicaid and Department of Mental Health files. Costs were extracted from Medicaid paid claims and from Department of Mental Health contracts and other financial documents. PRINCIPAL FINDINGS: Clients in the region allocating a greater proportion of its Department of Mental Health budget to community support services used far fewer hospital days, resulting in lower per person treatment expenditures. Outcomes, however, were not significantly different from outcomes of clients in the other regions. For all regions, substance abuse comorbidity increased hospitalization and total treatment costs. An individual-level cost-effectiveness analysis identified western Massachusetts (community-based care) as significantly more cost effective than the other two regions. CONCLUSIONS: Systems with stronger community-based orientation are more cost effective.