Adverse Selection, Moral Hazard, and Outlier Payment Policy

In this article, we analyze the rationale for introducing outlier payments into a prospective payment system for hospitals under adverse selection and moral hazard. The payer has only two instruments: a fixed price for patients whose treatment cost is below a threshold and a cost‐sharing rule for outlier patients. We show that a fixed‐price policy is optimal when the hospital is sufficiently benevolent. When the hospital is weakly benevolent, a mixed policy solving a trade‐off between rent extraction, efficiency, and dumping deterrence must be preferred. We show how the optimal combination of fixed price and partially cost‐based payment depends on the degree of benevolence of the hospital, the social cost of public funds, and the distribution of patients severity.