Theory and practice in the design of physician payment incentives

Combining the economic literature on principal-agent relationships with exa mples of marketplace innovations allows analysis of the evolution of method s for paying physicians. Agency theory and the economic principles of perfo rmance-based compensation are applied in the context of imperfect informati on, risk aversion, multiple interrelated tasks, and team production efficie ncies. Fee-for-service and capitation are flawed methods of motivating phys icians to achieve specific goals. Payment innovations that blend elements o f fee-for-service, capitation, and case rates can preserve the advantages a nd attenuate the disadvantages of each. These innovations include capitatio n with fee-for-service carve-outs, department budgets with individual fee-f or-service or "contact" capitation, and case rates for defined episodes of illness. The context within which payment incentives are embedded, includes such nonprice mechanisms as screening and monitoring and such organization al relationships as employment and ownership. The analysis has implications for health services research and public policy with respect to physician p ayment incentives.