Federal agencies, including DOD, can choose among numerous contract types to acquire products and services. One of the characteristics that vary across contract types is the amount and nature of the fee that agencies offer to the contractor for achieving or exceeding specified objectives or goals. Of all the contract types available, only award- and incentive-fee contracts allow an agency to adjust the amount of fee paid to contractors based on the contractor’s performance. Federal acquisition regulations state that award- and incentive-fee contracts should be used to achieve specific acquisition objectives, such as delivering products and services on time or within cost goals and with the promised capabilities. For award-fee contracts, the assumption underlying the regulation is that the likelihood of meeting these acquisition objectives will be enhanced by using a contract that effectively motivates the contractor toward exceptional performance. Typically, award-fee contracts emphasize multiple aspects of contractor performance in a wide variety of areas, such as quality, timeliness, technical ingenuity, and cost-effective management. These areas are susceptible to judgmental and qualitative measurement and evaluation, and as a result, award-fee criteria and evaluations tend to be subjective. Table 1 provides a description of the general process for evaluating the contractor and determining the amount of award fee earned. From fiscal year 1999 through fiscal year 2003, award- and incentive-fee contract actions accounted for 4.6 percent of all DOD contract actions over $25,000. However, when taking into account the dollars obligated— award- and incentive-fee contract actions accounted for 20.6 percent of the dollars obligated on actions over $25,000, or over $157 billion, as shown in figure 1. Our sample of 93 contracts includes $51.6 billion, or almost one-third, of those obligated award- and incentive-fee contract dollars. These obligations include award- and incentive-fee payments as well as other contract costs. DOD utilized the contracts in our sample for a number of purposes. For example, research and development contracts accounted for 51 percent (or $26.4 billion) of the dollars obligated against contracts in our sample from fiscal years 1999 through 2003; while non-research-and-development services accounted for the highest number of contracts in our sample. Further, we estimate that most of the contracts and most of the dollars in our study population are related to the acquisition of weapon systems. DOD has the flexibility to mix and match characteristics from different contract types. The risks for both DOD and the contractor vary depending on the exact combination chosen, which, according to the Federal Acquisition Regulation, should reflect the uncertainties involved in contract performance. Based on the results from our sample, about half of the contracts in our study population were cost-plus-award-fee contracts. The theory behind these contracts is that although the government assumes most of the cost risk, it retains control over most or all of the contractor’s potential fee as leverage. On cost-plus-award-fee contracts, the award fee is often the only source of potential fee for the contractor. According to defense acquisition regulations, these contracts can include a base fee—a fixed fee for performance paid to the contractor—of anywhere from 0 to 3 percent of the value of the contract; however, based on our sample results, we estimate that about 60 percent of the cost-plus-award- fee contracts in our study population included zero base fee. There is no limit on the maximum percentage of the value of the contract that can be made available in award fee, although the 20 percent included in the Space-Based Infrared Radar System High development contract we examined was outside the norm. The available award fees on all the award-fee contracts in our study population typically ranged from 7 to 15 percent of the estimated value of the contract. DOD’s use of award and incentive fees is symptomatic of an acquisition system in need of fundamental reform. DOD’s historical practice of routinely paying its contractors nearly all of the available award fee creates an environment in which programs pay and contractors expect to receive most of the available fee, regardless of acquisition outcomes. This is occurring at a time when DOD is giving contractors increased program management responsibilities to develop requirements, design products, and select major system and subsystem contractors. Based on our sample, we estimate that for DOD award-fee contracts, the median percentage of available award fee paid to date (adjusted for rollover) was 90 percent, representing an estimated $8 billion in award fees for contracts active between fiscal years 1999 and 2003. Estimates of total award fees earned are based on all evaluation periods held from the inception of our sample contracts through our data collection phase, not just those from fiscal years 1999 through 2003. Figure 2 shows the percentage of available fee earned for the 63 award-fee contracts in our sample. The pattern of consistently high award-fee payouts is also present in DOD’s fee decisions from evaluation period to evaluation period. This pattern is evidence of reluctance among DOD programs to deny contractors significant amounts of fee, even in the short term. We estimate that the median percentage of award fee earned for each evaluation period was 93 percent and that the contractor received 70 percent or less of the available fee in only 9 percent of the evaluation periods and none of the available fee in only 1 percent of the evaluation periods. March 29, 2006, emphasizing the need to link award fees to desired program outcomes. Award fees have generally not been effective at helping DOD achieve its desired acquisition outcomes, in large part, because award-fee criteria are not linked to desired acquisition outcomes, such as meeting cost and schedule goals and delivering desired capabilities. Instead, DOD programs structure award fees to focus on the broad aspects of contractor performance, such as technical and management performance and cost control, that they view as keys to a successful program. In addition, elements of the award-fee process, such as the frequency of evaluations and the composition of award-fee boards, may also limit DOD’s ability to effectively and impartially evaluate the contractor’s progress toward acquisition outcomes. Most award-fee evaluations are time-based, generally every six months, rather than event-based; and award-fee boards are made up primarily of individuals directly connected to the program. As a result of all these factors, DOD programs frequently paid most of the available award fee for what they described as improved contractor performance, regardless of whether acquisition outcomes fell short of, met, or exceeded DOD’s expectations. High award-fee payouts on programs that have fallen or are falling well short of meeting their stated goals are also indicative of DOD’s failure to implement award fees in a way that promotes positive performance and adequate accountability. Several major development programs— accounting for 52 percent of the available award-fee dollars in our sample and 46 percent of the award-fee dollars paid to date—are not achieving or have not achieved their desired acquisition outcomes, yet contractors received most of the available award fee. These programs—the Comanche helicopter, F/A-22 and Joint Strike Fighter aircraft, and the Space-Based Infrared System High satellite system—have experienced significant cost increases, technical problems, and development delays, but the prime systems contractors have received 85, 91, 100, and 74 percent of the award fee, respectively to date (adjusted for rollover), totaling $1.7 billion (see table 2). DOD can ensure that fee payments are more representative of program results by developing fee criteria that focus on its desired acquisition outcomes. For instance, DOD’s Missile Defense Agency attempted to hold contractors accountable for program outcomes on the Airborne Laser program. On this program, DOD revised the award-fee plan in June 2002 as part of a program and contract restructuring. The award-fee plan was changed to focus on achieving a successful system demonstration by December 2004. Prior to the restructuring, the contractor had received 95 percent of the available award fee, even though the program had experienced a series of cost increases and schedule delays. Importantly, the contractor did not receive any of the $73.6 million award fee available under the revised plan because it did not achieve the key program outcome—successful system demonstration. While DOD stated that award fee motivating excellent contractor performance by only paying award fees for above satisfactory performance arrangements should be structured to encourage the contractor to earn the preponderance of fee by providing excellent performance, it maintains that paying a portion of the fee for satisfactory performance is appropriate to ensure that contractors receive an adequate fee on contracts. In its March 29, 2006 policy memo, DOD reiterated this position and emphasized that less than satisfactory performance is not entitled to any award fee. In its March 29, 2006 policy memo, DOD provided guidance and placed several limitations on the use of rollover. DOD programs routinely engage in award-fee practices that are inconsistent with the intent of award fees, reduce the effectiveness of these fees as motivators of performance, compromise the integrity of the fee process, and waste billions in taxpayer money. Two practices, in particular, paying significant amounts of fee for “acceptable, average, expected, good, or satisfactory” performance and providing contractors multiple opportunities to earn fees that were not earned when first made available, undermine the effectiveness of fees as a motivational tool and marginalize their use in holding contractors accountable for acquisition outcomes. Although DOD guidance and federal acquisition regulations state that award fees should be used to motivate excellent contractor performance, most DOD award-fee contracts pay a significant portion of the available fee for what award-fee plans describe as “acceptable, average, expected, good, or satisfactory” performance. Although the definition of this level of performance varies by contract, these definitions are generally not related to outcomes. Some plans for contracts in our sample did not even require the contractor to meet all of the minimum standards or requirements of the contract to receive one of these ratings. Some plans also allowed for fee to be paid for marginal performance.