(MONEY Magazine) – Last August I got the rare chance to spend three days inside a hospital, undercover as a consultant, following a surgeon on his rounds. The doctor set the ground rules: I was free to talk to anyone I wanted and record my observations, with the proviso that I not identify the hospital or its staff in the magazine. The purpose was to see for myself why, despite hospitals' increasing efforts to contain costs, surgery is still so expensive-about $39,500, for instance, for a typical heart bypass and about $6,700 for a comparatively simple hernia repair. I soon discovered one reason: Hospitals practically throw money away. The hospital I visited disposes of roughly $1,000 of used supplies, from sheets to surgical tools, after most major surgeries. Also to blame, in my opinion: a clumsy accounting system that makes it difficult to determine the true cost of a particular procedure. Furthermore, a growing population of patients who don't pay in full puts tremendous pressure on hospitals to squeeze a profit out of those who do. The result: Some patients-or their insurers-pay four times as much as others for a comparable operation. Here is what I saw:

DAY ONE Changing nervously into scrubs and a surgical mask, I think about the huge responsibility that awaits my host on this typical day. I'll call him Dr. James. (All names in this story, including the hospital's, have been changed.) He is the chief of orthopedic surgery at St. Mark's, a 350-bed nonprofit community hospital in a major metropolitan area. Five men and women are counting on him to restore their ability to walk pain-free, in back-to-back joint-replacement operations that will last two hours each. He cannot have a bad day.

I head for surgery. In the doctors' lounge a group of physicians and nurses are noisily digging into a bag of tortilla chips and homemade salsa. It is not yet 8 a.m. I walk on, past the shelves and shelves of disposable supplies that line the hallway, through the metal-covered doors and into O.R. No. 7.

Under the glare of three high-tech lights, eight people in teal blue scrubs are congregated around the operating table-Dr. James, an attending scrub nurse, a scrub technician, a student fellow, two circulating nurses (who fetch supplies and stick bar-coded price tags for items used during surgery on a form that is later sent to billing), the anesthesiologist, and a representative from the company that supplies all of Dr. James' artificial knees and hips. The manpower cost for this operation alone, I later calculate, runs close to $5,000. The patient, already anesthetized, is about to get an artificial knee. He is 87 years old.

I watch as Dr. James cuts through the quadriceps tendon to open the cavity of the kneecap. The Beatles are playing on the radio. To keep from getting queasy, I strike up a conversation with Joe, the anesthesiologist. How much, I ask, will this surgery cost? Medicare will reimburse the hospital $9,454 for a joint-replacement operation like this one. (About 60% of Dr. James' patients, and 52% of the patients at St. Mark's, are on Medicare.) But, Joe notes, "Nobody knows what the true costs are."

I'm distracted by the whirring sound of power tools. Dr. James has picked up an electric saw and, in a scene straight out of Home Improvement meets Chicago Hope, is cutting off the worn surfaces of the patient's tibia (shinbone), femur (thighbone) and the patella (kneecap). Ron, the manufacturer's rep, who's on hand in case a problem arises with the joint implant, tells me that this particular prosthesis-the artificial knee-costs the hospital about $3,500. The patient will be billed around $7,000. The hospital has traditionally priced its artificial joints at two times the cost, to cover the expense of stocking $500,000 in prosthesis inventory.

Next door, in O.R. No. 8, Dr. James is now about to replace a 64-year-old man's worn-out artificial hip, installed 12 years earlier. It's nearly 10 a.m. I notice the waste that is accumulating-bright red bags full of hazardous stuff such as used needles and infectious tissue; clear bags full of blue paper wrappers that the surgical instruments came in. "It is unbelievable how much garbage gets generated in an operating room," a young nurse says. The culprit: disposable supplies. Hospitals like them because they reduce infection and because supplies that are used only once generally get charged to the patient. Disposables also reduce sterilization and laundering expenses. Today the vast majority of surgical supplies at St. Mark's, from the drapes (sheets) and paper scrub gowns to the plastic basin sets and surgical blades, are used once and thrown away. I later learn that disposables-which 30 years ago did not exist-are the hospital's second biggest expense, after staff.

Soon after Dr. James begins scraping surgical cement from his second patient's old hip, I decide to take a break. I head back to the doctors' lounge, where a medical technician is grousing that he ate too much hot sauce. Three nurses are sitting around a table talking to Julie, the administrative director of surgical services. She complains that in a battle for market share over the past decade the number of hospitals in the area with cardiac-care units has soared from three to 17; at the same time, the number of heart surgeries at St. Mark's has dropped from 900 a year to a less cost-efficient 350 or so. Most hospitals in town do fewer than 200 heart operations a year. An anesthesiologist named Marty says bluntly: "Efficiencies lost out to greed."

Who pays? As always, the patients with fee-for-service insurance, whose astronomical charges reflect hospitals' attempts to recoup losses in other areas. Medicare and managed-care patients actually get billed the same amount as fee-for-service patients-Medicare regulations specify that a hospital can't charge two patients different prices for the same procedure-but they reimburse the hospital at much lower rates, generally at or below cost. Medicare has a published schedule of what it will pay per diagnosis, while HMOs and other managed-care providers negotiate special contracts with the hospital. That means that the majority of a hospital's profits generally come from its fee-for- service patients. Today, 66% of St. Mark's patients get treated on a discounted basis, meaning that the remaining 34% carry a heavy load.

A printout of Dr. James' inpatients who were discharged in June shows the extent of the imbalance. One large West Coast-based health maintenance organization reimbursed the hospital a preset $6,564 for a complicated hip- replacement operation on one of its customers. The actual bill had been $36,835. For a similar operation priced at $31,405, a fee-for-service insurer paid the hospital $26,694 (with the patient, subject to policy limits, normally responsible for the balance). "The truth is that people who can and will pay are being punished severely," says Dr. James.

After a noontime lunch of salad with turkey strips in the doctors' dining room (free for staff members), I head back to O.R. No. 7, where Dr. James is busy replacing a 64-year-old woman's knee. He traces a line on her leg with a disposable skin-marking pen that costs the hospital less than $1, then tosses it aside for my sake with a flippant "28 bucks." (That's what her insurer will be billed for it.) "The plastic sheet on her leg: 59 bucks. Cost: $8. It's a racket."

With a deft slice of his knife, he cuts open the leg, shaves off the damaged cartilage behind the knee and eventually fits and drills a patellar button (an artificial-knee component) into place. I know I am seeing the best surgery that medicine can buy. It crosses my mind that if it were me on that table, I'd be hard-pressed to figure out which costs could be cut.

Just after lunch I had joined Dr. James on his post-op rounds. There, perched up on his pillows, grinning from ear to ear, was the 87-year-old man I'd watched go under the knife at 8 a.m. He will soon be walking again. The total hospital bill for his operation: $29,423.

It's now 2 p.m., and Dr. James is beginning his fourth surgery. Except for a 15-minute break to wolf down some spaghetti and meatballs, he hasn't stopped. While he works at removing a painful growth of bone that has formed in a 73-year-old man's hip, I talk to Marty, the anesthesiologist. He pulls out a 10ml vial of lidocaine. As a patient at a nearby hospital, his wife was charged $36 for this; the true cost is about $3.

Dr. James toils away. His last surgery begins at 4 p.m. and ends at 6. He then heads out for a beer with his staff and home for dinner. His surgical billings for the day: approximately $18,000.

DAY TWO Today I visit Dr. James' office. His administrator, Barbara, thinks insurance companies drive up costs by requiring reams of needless paperwork. To prove it, she introduces me to an employee named Beth, who does nothing but fill out forms and call insurance companies all day to get the okay Dr. James needs to perform his surgery. It is, it turns out, a fairly meaningless exercise. "I've done this for four years, so I know what they're looking for," Beth says. "About 80% give me an authorization while I'm on the phone. The rest usually call back with an okay in two to three days." She's never gotten an outright no for anyone who wasn't suffering from a pre-existing condition.

Dr. James is back at St. Mark's, checking up on his patients. In a typical week, he performs surgery on Tuesday and Thursday and sees patients on the other days. St. Mark's can't afford to lose him, because his roughly 450 joint- replacement operations per year account for about a third of St. Mark's inpatient orthopedic business. And that business can be lucrative: At an average price of $6,000 per prosthesis, 450 surgeries adds up to annual charges of $2.7 million on prosthesis sales alone. Since the average prosthesis costs $3,000, that's a profit of $1,350,000.

Of course, St. Mark's doesn't collect all of that, since two-thirds of its patients don't reimburse the hospital the full amount. But the profits from the one-third who do pay in full come to about $450,000 a year, just on implants-and that doesn't include what the hospital makes on the surgery itself.

DAY THREE I'm back in the O.R., pondering a disturbing possibility: Because HMO patients pay sharply discounted fees, they don't get the same care that fee-for- service patients do. "One HMO patient came here for open-heart surgery and was admitted the day of surgery, having never met the physician," Julie, the administrator, had confided two days ago. "Physicians bicker over who has to see these patients post-op. I see ads on TV that say: 'I don't know what I'd have done without [my HMO].' Boy, I'm not seeing that kind of care, and I'm across the hall from them."

I decide to check out what's on all the metal shelves lining the hallways leading to the operating rooms. On one side of the hall, seven racks with five to six shelves each sit side by side, loaded with disposable items. Single-use anesthesia ventilator tubes ($148.40 for a case of 20); anesthesia breathing bags ($96.23 for a case of 50); surgical gloves ($74 for a box of 40). In a little room off the hallway, several shelves are stocked with disposable surgical blades. One example: 4.5 Turbowhisker arthroscopic-surgery blade-$58 per blade. I look down at the Baxter's Convertors Dura-fit paper shoe covers on my feet. My cap is disposable too. All one-use-only fodder for the local landfill.

When I later ask Julie about St. Mark's dependence on disposables, she's quick to defend the practice. "I priced it out a year ago and found no savings in shifting to reusables," she says. But some studies contradict that contention. One such, reported in 1993 in Materials Management in Health Care, the American Hospital Association's hospital-supply magazine, found that hospitals can cut purchasing and waste-disposal costs by as much as a third by switching from disposable to reusable linens.

Figuring out the true expense of hospitalization is a problem, Julie admits. "Hospitals are way behind in looking at costs," she says. "We have mechanisms in place, but they are clumsy. So we do a whole lot of guessing." St. Mark's has been talking about improving its cost-accounting system for four years. But that, says Julie, would "add costs at a time when we are trying to reduce our costs. If we'd built these [cost] models when we had resources, we'd have been better off. But back then we made so much money that understanding costs didn't matter to us."

Doctors are part of the problem too: Julie points out that many hospital decisions are driven by physician preferences. Dr. James insists on using Howmedica prostheses, for example, while a colleague will only use Johnson & Johnson. That makes it harder for hospitals to negotiate volume discounts. Says Julie: "As long as they are making decisions on products, I can't go into the market and get the best price."

As I contemplate Julie's dilemma, Dr. James shows up at her office; it's time to go. Changing out of my scrubs, a kaleidoscope of images whirls in my head: Dr. James and his team toiling through 18 hours of surgery in two days; an 87-year-old man grinning happily in post-op; bags and bags of medical waste. Dr. James and I ride down the elevator in silence. Later I tell him about my conversation with Julie. He agrees in principle that doctors' product preferences are part of the problem but adds, "As chairman of orthopedics, to force my colleagues to use the vendor I prefer would be wrong." Thinking of his own elderly patient base, he adds: "I could look at a patient and decide, 'This guy is going to die in five years anyway, so I'll use a cheaper, potentially less durable prosthesis.'" But, he muses, dismissing the tactic: "What if he doesn't die?"