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OBJECTIVE: The long-run cost savings potential of private sector reform efforts, such as selective contracts with providers, depends in part on the relationship between procedure-specific volume and average hospital resources that are consumed in treating patients associated with that specific procedure. Study examines a model that estimates the relationship between hospital procedure-specific volume and average hospital treatment costs, using an elective surgical procedure as an example. DATA SOURCES: Medicare Provider Analysis and Review (MedPAR) files for 1989 for hospitalizations in which a Medicare beneficiary received a knee replacement (KR) surgery during 1989. Hospital information was obtained from the American Hospital Association's 1989 Annual Survey. All patient-level data were aggregated to the hospital level to create a data file, with the hospital as the unit of observation. STUDY DESIGN: This study used administrative claims data and regression analysis to estimate the effect of hospital procedure-specific volume on average hospital treatment costs of patients receiving KR surgery. We also examined the stability of the volume-cost relationship across hospitals of different sizes. PRINCIPAL FINDING: The average treatment costs associated with KR surgery are inversely related to a hospital's KR volume in the regression equation estimated using all hospitals performing KR surgery. The inverse relationship between cost and volume is found to be robust for different-size hospitals. CONCLUSIONS: The potential cost savings associated with performing KR surgery at incrementally higher hospital volume level can amount to as much as 10 percent of the hospital's average treatment cost. However, the incremental cost savings associated with increased patient volume depends on the hospital's current volume level and its size.