The rapid growth in outpatient expenditures and the congressional mandate for development of a prospective payment system (PPS) for these expenditures are discussed. Extension of diagnosis-related groups to outpatient care is shown to be infeasible. Alternative patient classification schemes and options for defining the unit of payment and establishing weights and rates are discussed. A PPS primarily controls price and can only address volume by defining a broad unit of payment, such as an episode of care. Therefore, adoption of a volume performance standard approach could be effective. Outpatient payment policies must be integrated with those of other ambulatory care providers.