Risk Adjustment, Innovation and Prevention

Widespread integration of market-based incentives into healthcare systems calls for — and has elicited — increasing adoption of risk adjustment. By deterring selection, risk adjustment helps to assure fair and efficient payments among health insurers or capitated provider groups. However, since conventional risk adjustment allocates funds among regions or insurers according to current population health status, it does not reward — indeed, it penalizes — provider preventive efforts that improve population health. This prevention penalty of risk adjustment represents a hidden cost of unclear magnitude, undermining provider incentives for innovations in health promotion. We develop a theoretical model of selection and prevention demonstrating this problem with conventional risk adjustment and suggesting a simple alternative: risk adjustment should be linked to pay-for-performance for prevention. JEL classification: I1