With Japanese hospital financing reform, a prospective payment system (PPS) has been established for inpatient care to replace the traditional fee‐for‐service remuneration of hospitals. This paper evaluates the effect of the reform on technical and cost efficiency of local public hospitals. Efficiency is estimated non‐parametrically using two‐stage data envelopment analysis with bias correction through bootstrap, and parametrically applying stochastic frontier analysis. The descriptive analysis shows that efficiency declines after the introduction of PPS. Difference‐in‐difference estimations reveal that PPS results in a limited efficiency gain, which might be related to inadequate incentives created by the two‐part PPS tariff in Japan.