What this year's Nobel Memorial Prize in Economics means for ACOs, physician compensation

Two economists were awarded the Nobel Memorial Prize in Economic Sciences Monday for their work in contract theory — work that could inform physician-hospital, compensation and value-based care agreements.

The economists, Oliver Hart, PhD, a professor at Harvard, and Bengt Holmström, PhD, a professor at MIT, help explain how to better design contracts to improve output and align incentives. The awarding body, Royal Swedish Academy of Sciences, notes that contract theory cannot provide definitive answers, but can help provide structure and evaluate contract effectiveness.

For example, under pay-for-performance agreements, physicians are usually paid an incentive-based bonus on top of fee-for-service compensation. These payments are based on agreed-upon measures of quality and cost. Dr. Holmström's work suggests payment under this type of structure should be tied to the broadest possible measure of performance. He argues that a manager's pay should not depend entirely on his or her firm's share price, because this could reward the manager for good or bad luck if an industry is up or down. Instead, pay should be linked to the firm's share price relative to the overall industry performance, according to Dr. Holmström.

His work also demonstrates performance that is difficult to measure should be compensated with a structure that is more fixed. Likewise, pay should be more fixed if a person is responsible for a variety of tasks. For example, physicians could begin to focus too closely on improving specific measures while neglecting others to improve compensation. They would be "teaching to the test," according to Dr. Holmström's work.

These principles also play out in ACOs, where teamwork can lead to free-riding. Under an ACO's framework, more patients and physicians are needed to ensure quality metrics are precise, hence Medicare's minimum requirement for ACOs to have 5,000 beneficiaries. However, this also means individual physician behavior has less influence on the group's overall quality performance, leading to the possibility of free-riding, or those who shirk responsibilities and benefit from the efforts of others. Dr. Holmström suggests employing an outside owner or deferring portions of compensation can help mitigate this problem.

Dr. Hart's work can help inform physician-hospital contracts. It focuses on incomplete contracts, or those that face unforeseen challenges that could not be anticipated when drawing up the agreement. Because future events are unknown, Dr. Hart posits that contracts should instead outline who has the right to make the decision if both entities do not agree. When contracting is complex and many outcomes are unforeseen and therefore cannot be measured and benchmarked, Dr. Hart suggests using decision allocation rights instead.

He also provides theory to guide ownership decisions and financial contracts. Dr. Hart suggests some contracts, particularly those that require entrepreneurship or innovation, give the manager or entrepreneur the right to make decisions for the business if performance is positive, but allow investors to step in if performance lags.

The work of Drs. Hart and Holmström provides healthcare organizations the tools to analyze the financial terms of contracts as well as how control and decision rights are allocated between physicians, hospitals and other stakeholders.


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