Performance Indicators for Quality with Costly Falsification

Performance indicators are increasingly used to regulate quality in health care and the public sector. We develop a model of contracting between a purchaser and a provider under the following assumptions: (a) providers have private information about their own ability and (b) they can engage in costly manipulation of quality measures. If the contract is separating, manipulation reduces the optimal quality effort but increases the quality targets. If the purchaser's benefit from quality is sufficiently concave, then pooling of high‐ability types (or all types) turns out to be optimal. (Partial) pooling provides a rationale for quality ceilings and minimum quality standards.