This study measures the effect of TennCare, a Medicaid managed care reform initiated in 1994, on the efficiency of hospitals in Tennessee. We apply a multiple-output stochastic frontier approach to a panel dataset that represents all short-term acute care hospitals operating in Tennessee for 1990–2001 and find a modest gain in operating efficiency overall. Our results also reveal that the effect of reform on hospital efficiency varies significantly with the admitting hospital’s TennCare patient load and whether the hospital is located in an urban or rural area. During the study period, high-TennCare hospitals in urban areas saw efficiency gains in the 4 years immediately after the implementation of the program while high-TennCare hospitals in rural areas had significant efficiency losses. The effects immediately following the program’s implementation on low-TennCare urban and rural hospitals are similar to those experienced by hospitals with high-TennCare admissions but the magnitude of the effects are much smaller. Policymakers considering large scale reforms of this type should be careful to take into consideration the likely differential responses from urban and rural hospitals that are prone to differ in payer mix and capacity to improve efficiency.