This report of the San Francisco (California) Regional Office of the Inspector General concludes that the U.S. Department of Education should improve its present method of allocating special education funds among the states. It finds that the basis of these allocations, reported numbers of students receiving special education in each state, is unreliable. It recommends that allocations be made, instead, on the basis of a state's total population, age 3 through 21, weighted by poverty measures. The report also recommends re-evaluation of the need to classify and report students by disability categories. It finds six indications of the present system's unreliability: (1) states report widely divergent proportions of children in each disability category; (2) local school districts report widely divergent proportions of children in each disability category; (3) states' enrollments of students in special education are inconsistent with other statistics on the number of persons with disabilities; (4) reports and studies have cited problems with the child count process; (5) state and local special education officials have cited problems with the present system; and (6) most of the independent groups perceive deficiencies in the present special education program process. Attached material includes a table of percentages of students with disabilities by state, a comparison of work-related disabilities versus students counted as disabled, and a listing of groups contacted. (DB)