Title

Revisiting Incentive-Based Contracts

Document Type

Article

Publication Date

January 2017

Abstract

Incentive-based pay is rational, intuitive, and popular. Agency theory tells us that a principal seeking to align its incentives with an agent’s should be able to simply pay the agent to achieve the principal’s desired results. Indeed, this strategy has long been used across diverse industries—from executive compensation to education, professional sports to public service—but with mixed results. Now a new convert to incentive compensation has appeared on the scene: the United States’ behemoth health care industry. In many ways, the incentive mismatch story is the same. Insurance companies and employers are concerned about constraining the cost of care, and patients are concerned about quality of care. Physicians lack an adequate financial incentive to pay attention to either. Health care’s recent move away from the traditional fee-for-service compensation model to incentive pay is perhaps unsurprising.But there is a problem: mixed preliminary evidence and potential mal-effects on vulnerable third-party patients. This Article employs a new lens—the legal and behavioral literature on optimal contract specificity—to suggest why incentive pay is problematic and why the health care experience will be no different than other industries. The use of incentive pay is a change in contract drafting strategy, a decision to write a more detailed, control-based contract rather than one that relies on discretion. The contracts literature suggests that this strategy will only work well where simple compliance is the goal rather than creativity or innovation. The health industry will not succeed in implementing incentive pay better than other industries have. What it needs is to recognize the limits of incentive pay and implement it sparingly. The new Trump administration may be particularly primed to heed this call.

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