Revisiting Incentive-Based Contracts

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.