Analysis of Medicare Pay-for-Performance Contracts

Medicare has sought to improve patient care through pay-for-performance (P4P) programs that better align hospitals’ financial incentives with quality of service. However, the design of these policies is subject to a variety of practical and institutional constraints, such as the use of “small” performance-based incentives. We develop a framework based on a stylized principal-agent model to characterize the optimal P4P mechanism within any set of feasible mechanisms in the regime of small incentives. Importantly, our feasible set can be flexibly modified to include institutional constraints. We apply our results to examine debated design choices in existing Medicare P4P programs, and offer several insights and policy recommendations. In particular, we find that these mechanisms may benefit by incorporating bonuses for top-performers, and using a single performance cutoff to uniformly assess performance-based payments. We also examine a number of comparative statics that shed light on when P4P mechanisms are effective.