INCENTIVE CONTRACTS FOR PUBLIC HEALTH CARE PROVISION UNDER ADVERSE SELECTION AND MORAL HAZARD1

Any health care system should provide treatment so as to maximise expected social welfare. Whether health care provision is public or private, the implementation of this outcome, through the way health care providers or hospitals are compensated for the cost of providing services, has been a policy issue for a long time in a number of countries. Many payment reforms are now based on a (high-powered) DRG-price system, so as to induce cost consciousness. In this paper we analyse this issue for a public health care system, where public hospitals offer treatment. Each hospital is privately informed about the true disease of any patient, while cost control cannot be verified, and offer treatment with a stochastic outcome. Ex post outcome and realised cost of treatment can be verified, with cost depending on treatment intensity, cost-reducing effort and the type of disease. With a disease-contingent transfer, the hospital is able to capture a socially costly rent, because of tax distortions and because rent has no (direct) weight in the welfare function. When type of treatment can be verified, treatment should be less intensive than unde