Selection incentives in a performance-based contracting system.

State and local governments are major sources of financing for substance abuse services. In 1997, 27 percent of total mental health and substance abuse spending was funded by state or local governments (Mark et al. 2000). Like other payers, governments need efficient forms of payment to offer providers financial incentives to achieve cost-efficiency and to allow payers to monitor performance. Performance-based contracting (PBC) has been promoted by the Institute of Medicine (IOM) as a “promising mechanism to manage and ensure the effectiveness of substance abuse services” (Institute of Medicine 1990). Generally, performance-based contracting ties continuation of funding or the level of funding to certain treatment outcomes. Maine implemented a PBC system in fiscal year 1993. In this system, nonprofit providers (programs) of substance abuse treatment received budgets each year from the state government to finance the cost of treating clients who could not pay. Maine monitored and evaluated programs’ performance to “redirect funds, away from less efficient programs and toward programs which have proven themselves able to ‘produce’ good treatment outcomes” (Commons, McGuire, and Riordan 1997). Performance-based contracting is designed to encourage providers to provide care to high-priority state clients in a cost-effective manner, but it may have unintended consequences: selection incentives may lead to behavior against the payer's interests. The basic issue is that since providers’ performance is rewarded and usually measured by the average performance of clients at discharge, providers have incentives to select the less severely ill clients who are more likely to have better performance levels at discharge in the first place. Thus, providers may avoid treating more severely ill clients. Problems related to selection have attracted attention in the literature on optimal payment systems (for an excellent discussion, see Newhouse 1996). When providers are paid on the basis of cost, there is no direct financial incentive to select a low-cost patient over a high-cost one. In a prospective payment system, however, providers receive a fixed fee for each patient. Treatment cost for severely ill patients can be above the fixed fee, motivating providers with financial incentives to “dump” high-cost patients to improve profitability. Researchers have looked for empirical evidence of a selection problem in various contexts, but data limitations have precluded directly testing whether more severely ill patients are denied treatment. Instead, most studies compare lengths of stay or other related factors across different reimbursement systems (Newhouse 1989; Hill and Brown 1990; Weissert and Musliner 1992; Ellis and McGuire 1996). The PBC system is not a prospective payment system. It allocates public funds among providers, who are then expected to deliver the contracted units of services. Therefore, funding is not tied to specific individuals. Because of this difference, the incentives for selecting favorable patients also vary. Under prospective payment, more severely ill patients might be rejected for treatment because their treatment costs are higher than the fixed payment and providers will lose money by treating them. Under a PBC system, however, more severely ill patients might be rejected for treatment because they will lower the providers’ overall performance. Providers with bad performance can be punished with less funding in the next period. Both systems provide incentives for health care providers to select people. This study provides important empirical evidence of selection problems in the health care sector for the first time by examining whether nonprofit providers have selected less severely ill clients into their treatment programs in one specific performance-based contracting system, the PBC system in Maine. While several studies have examined other aspects of the PBC system in Maine, this study's primary contribution is directly testing for selection of patients by their severity levels. Commons, McGuire, and Riordan (1997) studied the direct effect of this system on providers’ performance. They found that providers’ performance effectiveness was positively related to the innovation of PBC. In post-PBC periods, 60 percent of the programs achieved the effectiveness indicators defined by the state regulator while only 50 percent did so prior to PBC implementation. At the same time, the PBC system might cause some unintended provider behavior such as misreporting, which could make performance look better without actually improving the treatment quality (Commons and McGuire 1997). Performance improvement cannot be completely interpreted as the result of an increase in treatment quality without controlling for the unintended effect. Given that performance evaluation is based on the information supplied by providers, Lu (1999) argued that providers had an incentive to misreport treatment outcomes. By separating the impact of the PBC on treatment effectiveness into a “true effect” that captured providers’ improved effect induced by PBC and a “reporting effect” that was the result of providers’ misreporting, she found that misreporting existed after the implementation of PBC. The present paper tests for the existence of selection behavior induced by the PBC system.