Theory and practice in the design of physician payment incentives

Combining the economic literature on principal-agent relationships with examples of marketplace innovations allows analysis of the evolution of methods for paying physicians. Agency theory and the economic principles of performance-based compensation are applied in the context of imperfect information, risk aversion, multiple interrelated tasks, and team production efficiencies. Fee-for-service and capitation are flawed methods of motivating physicians to achieve specific goals. Payment innovations that blend elements of fee-for-service, capitation, and case rates can preserve the advantages and attenuate the disadvantages of each. These innovations include capitation with fee-for-service carve-outs, department budgets with individual fee-for-service or "contact" capitation, and case rates for defined episodes of illness. The context within which payment incentives are embedded, includes such non-price mechanisms as screening and monitoring and such organizational relationships as employment and ownership. The analysis has implications for health services research and public policy with respect to physician payment incentives.