NOTE: This article is the seventh in a series of 10 articles and is part of our Health Economics 101 course. You can find a course overview and links to all 10 course modules here:
- Health Economics 101: Course Overview
- Module 1: Introduction to Health Economics
- Module 2: Demand and Supply of Health Care
- Module 3: Health as an Economic Good
- Module 4: Health Insurance and Risk Management
- Module 5: Economic Evaluation in Health Care
- Module 6: Health Systems and Health Care Financing
- Module 7: Market Competition and Provider Payment Mechanisms
- Module 8: Equity and Efficiency in Health Care
- Module 9: Health Policy and Regulation
- Module 10: Current Issues and Future Directions in Health Economics
Market Competition and Provider Payment Mechanisms
The way health care providers are paid has a profound influence on the organization, delivery, and efficiency of health services. Payment mechanisms not only determine financial incentives but also shape provider behavior, care quality, and patient outcomes. Alongside this, the degree of market competition—or its absence—interacts with payment structures to affect system performance. Understanding these dynamics is central to designing health systems that promote efficiency, equity, and quality.
Types of Payment Models
Provider payment mechanisms are the methods through which health care providers are reimbursed for their services. The main models include Fee-for-Service (FFS), Capitation, Diagnosis-Related Groups (DRGs), and Pay-for-Performance (P4P). Each model creates different incentives and trade-offs.
1. Fee-for-Service (FFS)
Under FFS, providers are paid for each individual service delivered (e.g., consultations, tests, procedures). This model:
- Encourages high service volume
- Offers flexibility and responsiveness to patient needs
- Risks overutilization, cost inflation, and fragmented care
While common in many health systems, FFS has been widely criticized for incentivizing quantity over quality.
2. Capitation
Capitation involves paying providers a fixed amount per patient per time period (e.g., per member per month), regardless of the number of services provided. This model:
- Promotes cost containment
- Encourages preventive and primary care
- Risks under-provision or avoidance of high-risk patients (known as “cream-skimming”)
Capitation is frequently used in primary care, especially in managed care settings like Health Maintenance Organizations (HMOs) in the United States.
3. Diagnosis-Related Groups (DRGs)
DRGs are a case-based payment model used primarily for hospital reimbursement. Providers receive a fixed payment based on a patient’s diagnosis and expected resource use. This model:
- Rewards efficiency in care delivery
- Reduces unnecessary length of stay
- Can incentivize early discharge and upcoding (classifying patients into more expensive categories)
DRGs are widely used in countries such as the United States, Germany, and Australia.
4. Pay-for-Performance (P4P)
P4P programs link payment to quality indicators or outcome measures, such as adherence to clinical guidelines, patient satisfaction, or hospital readmission rates. This model:
- Aligns incentives with quality improvement
- Encourages data collection and transparency
- Risks gaming, neglect of unmeasured services, or targeting easy-to-achieve metrics
P4P is often layered on top of other payment models and continues to evolve as health systems seek to balance incentives.
Impact of Payment Models on Health Provider Behavior
Provider payment mechanisms create powerful incentives that can influence multiple aspects of provider behavior, including:
1. Volume and Type of Services
FFS systems typically lead to higher service volume, potentially beyond what is clinically necessary. In contrast, capitation and DRGs create incentives to limit services to reduce costs.
2. Care Coordination
Bundled or population-based payments (e.g., capitation) tend to promote care integration and coordination, whereas FFS may fragment care across multiple providers.
3. Patient Selection
Under capitation or fixed payments, providers may seek to avoid high-risk patients or those with complex needs, unless risk adjustment mechanisms are in place.
4. Innovation and Prevention
Payment models that offer upside financial risk (e.g., shared savings or P4P) can motivate providers to invest in preventive care, health IT, and process innovations.
5. Administrative Complexity
Multiple payment mechanisms can increase administrative burden and complexity, especially when different payers use varying rules and metrics.
Ultimately, provider responses depend on the design details, the regulatory context, and the strength of performance monitoring systems.
Competition vs. Regulation in Health Care Markets
Health care markets are inherently different from classical competitive markets due to:
- Information asymmetry
- Externalities
- Uncertainty
- Barriers to entry and exit
As a result, the role of competition must be balanced carefully with regulation.
1. Competition Among Providers
When designed effectively, provider competition can:
- Improve quality
- Enhance efficiency
- Reduce prices (in elective services or transparent pricing markets)
However, evidence is mixed. For example, in systems like the NHS, managed competition among providers for contracts or patients has shown some benefits in improving outcomes—but only when quality data is transparent and monitored.
2. Competition Among Insurers
Insurance competition, as seen in countries like Germany and the Netherlands, can:
- Promote innovation
- Improve responsiveness to patient preferences
But it can also result in risk selection, marketing-driven behavior, and inefficiencies without risk adjustment and regulation.
3. Role of Regulation
Regulation remains essential for:
- Setting quality standards
- Preventing market abuses
- Ensuring equitable access
- Designing and enforcing risk adjustment mechanisms
For example, in systems with mixed public-private models, regulators ensure that public goals (e.g., universal coverage, quality assurance) are achieved even when private actors are involved.
Conclusion
Provider payment mechanisms and market structures are foundational components of health system performance. Whether incentivizing volume through fee-for-service, promoting prevention via capitation, rewarding efficiency with DRGs, or enhancing quality via pay-for-performance, each model shapes provider behavior in different ways. Similarly, competition can spur improvements under the right conditions but must be balanced with regulation to ensure equity and efficiency. Policymakers must navigate these complex dynamics to align incentives with the overarching goals of better health outcomes, financial protection, and system sustainability.
References
- Ellis, R. P., & McGuire, T. G. (1990). Provider Behavior Under Prospective Reimbursement: Cost Sharing and Supply. Journal of Health Economics, 9(4), 419–437.
- Robinson, J. C. (2001). Theory and Practice in the Design of Physician Payment Incentives. Milbank Quarterly, 79(2), 149–177.
- OECD (2016). Better Ways to Pay for Health Care. OECD Publishing.
- Busse, R., Geissler, A., Quentin, W., & Wiley, M. (Eds.). (2011). Diagnosis-Related Groups in Europe: Moving Towards Transparency, Efficiency and Quality in Hospitals. European Observatory on Health Systems and Policies.
- Christianson, J. B., Leatherman, S., & Sutherland, K. (2008). Financial Incentives, Healthcare Providers and Quality Improvements: A Review of the Evidence. Health Policy, 88(2-3), 137–148.
