Moral Hazard in Expert Services: Evidence from an Intervention to Reduce Health Care Spending in China

This paper examines how physicians respond to …nancial incentives when there are con‡icts of interest using a quasi-experimental approach in a unique setting— the health services market in China. In recent years, drug expenditures in China have accounted for nearly 50% of total health expenditures, which is much higher than the world average. Hospitals own pharmacies and generate revenue from drug sales. Physicians are salaried and may receive under-the-counter commissions from drug manufacturers for prescribing particular drugs. To reduce drug expenditures, China imposed a policy that penalized hospitals with high drug percentages (i.e., drug sales as a percentage of total revenue). This paper studies one hospital that responded by instituting a compensation scheme that punished physicians whose drug percentages exceeded a specialty-speci…c threshold. Using a unique transaction-level dataset, I …nd that the compensation scheme resulted in unintended consequences: rather than decreasing drug utilization, physicians responded by increasing the utilization of non-drug services, especially for diagnostic tests. Because the policy had no signi…cant e¤ect in reducing drug expenditures, its overall e¤ect was to increase total expenditures. This …nding is consistent with the inducement hypothesis predicted by agency theory. I also …nd that increased non-drug expenditures were concentrated among insured patients, suggesting that physicians have stronger incentives to act in the patients’interests than in the interests of the third-party payer. Department of Management & Strategy, Kellogg School of Management, Northwestern University, [email protected]. I am indebted to David Dranove, Leemore Dafny, Thomas Hubbard and Craig Garthwaite for their continuous support and encouragement. This paper has bene…ted from useful discussions with Michael Mazzeo, Alberto Salvo, Frank Limbrock, Guy Arie, Yang Zhang and Chris Ody. I also thank the seminar participants at Kellogg School of Management. All errors are mine.