Objective: To investigate the impact of disability transitions on annual Medicare Part A and B cost. Method: We analyzed 6,385 community-dwelling beneficiaries who were continuously enrolled in fee-for-service Medicare Part A and B from 2008 to 2009. We estimated adjusted effects of disability transitions on Medicare cost using a generalized linear model. Results: Transitions to more severe disability states were associated with significantly higher average annual Medicare cost ranging from US$2,639 to US$5,405. Lower spending levels were observed for beneficiaries with improvements in functioning. Beneficiaries who transitioned from severe to moderate activities of daily living (ADLs) disability cost significantly less (–US$6,045) than those who remained severely disabled. Discussion: Interventions aimed at preventing disability progression and efforts to restore functional capacity are promising strategies for containing costs and generating savings for Medicare. Future research is needed to assess the longer term impact of disability in association with the progression of chronic conditions.