Payment systems affect providers’ incentives and how they compete in different ways. Some may have desirable features that promote efficiency and favour lower prices, but at the same time may provide adverse incentives, for example in terms of cream skimming or quality deterioration. This section provides some insights into how the different payment systems affect incentives and competition, based on the economic literature.
The fundamental incentive under FFS is to increase the volume of services, subject to the fee being sufficient for the provider to profit. Since each additional service generates additional profit, providers face no financial penalty for delivering more care and no financial reward for restraint. Providers therefore compete on quantity while price is typically set administratively or negotiated between providers and insurers. The volume incentive may also contribute to market dynamics in which providers invest in capacity expansion and service proliferation — potentially feeding into the consolidation dynamics discussed in the context of financialisation, where investor-backed chains may exploit FFS incentives through upcoding and service volume expansion. This incentive to expand volume and capacity creates a well-documented risk of supplier-induced demand: providers may recommend or perform services beyond what is clinically necessary, particularly where information asymmetries prevent patients from evaluating the appropriateness of care (McGuire, 2000[51]).
Capitation inverts the FFS incentive: since revenue is fixed per patient, the provider’s financial interest lies in minimising the cost of care delivered. This creates incentives for efficiency but also for underprovision, that is delivering fewer services than clinically warranted, and for risk selection (or ‘cream-skimming’), that is preferentially enrolling healthier patients who are cheaper to treat while avoiding sicker ones. Under capitation, competition shifts from volume to patient enrolment: providers compete to attract and retain patients (or, in managed-competition systems, insurers compete to attract enrolees). This can in principle generate positive quality competition: providers improve care to attract patients; the risk selection incentive may however partially undermine this. Capitation may also encourage consolidation and vertical integration, since providers can capture savings from co-ordinating care across settings. Systematic reviews in the context of physician payment methods find that capitation, relative to FFS, is associated with lower utilisation of services and somewhat lower healthcare costs, but also with shorter consultations and, in some contexts, lower patient satisfaction (Gosden et al., 2000[52]; Scott et al., 2011[53]).
DRG-based payment creates the conditions for yardstick competition among hospitals: because payment rates are standardised, hospitals that treat patients more efficiently earn surpluses, while inefficient hospitals incur losses. This competitive pressure can drive improvements in productive efficiency. However, the upcoding and selection incentives can distort competition, rewarding strategic coding rather than genuine efficiency. DRG systems also interact with market structure: in concentrated markets, hospitals may face weaker competitive pressure to reduce costs, while in more competitive markets, the benchmarking properties of DRGs may amplify quality competition. Similarly to FFS, DRGs provide incentives to increase the number of patients treated, without rewarding quality of care and outcomes (Lindner and Lorenzoni, 2023[48]). The introduction of DRG-based payment has been extensively evaluated. Meta-studies confirm that DRGs significantly reduce average length of stay without a consistent adverse effect on in-hospital mortality, though readmission effects are more ambiguous (Chen et al., 2023[54]). Upcoding has also been documented: a study of France’s DRG refinement found that the introduction of a finer classification triggered a learning effect in which hospitals (particularly for-profit ones) systematically classified patients into higher-paying groups, resulting in a measurable budget transfer from public to for-profit hospitals (Milcent, 2020[55]).
Global budgets can dampen competition because they disconnect provider revenue from the ability to attract patients. A hospital under a global budget has limited financial incentive to compete for additional patients, since additional volume does not generate additional revenue and may increase costs. This means that, in the absence of quality-linked adjustments, global budgets can insulate providers from competitive pressure. The trade-off between financial stability and efficiency incentives explains the temporary suspension of activity-based payments in England during the Covid-19 pandemic to ensure that revenues were predictable, and the subsequent transition back to activity-based elements to incentivise efficiency (Waitzberg et al., 2024[56]; Milstein and Schreyögg, 2024[57]).
Bundled payments reshape the competitive unit from the individual service to the care episode, which can have effects on how suppliers compete. They favour providers capable of managing the full care pathway (typically larger, more integrated organisations) and may disadvantage smaller or more specialised providers unable to absorb the financial risk of the full episode. This can accelerate consolidation and vertical integration, as providers seek to internalise the co-ordination gains that bundled payment rewards. It also creates a tension: bundled payments may improve allocative efficiency by incentivising value, but the resulting provider consolidation may reduce competitive pressure in the longer term. The design of the bundle (breadth of services included, episode duration, risk adjustment, and shared-savings mechanisms) is therefore critical for balancing efficiency incentives against market power concerns. Empirical reviews conclude that the evidence base remains modest in scale and that implementation outside the United States has been limited (Lindner and Lorenzoni, 2023[48]).
P4P interacts with competition in important ways. Where quality indicators are publicly reported alongside payment incentives, P4P can strengthen the link between quality and patient choice. However, P4P may place at a disadvantage those providers serving low-income patients, since socioeconomic factors affect health outcomes independently of care quality, potentially penalising safety-net providers. If P4P rewards are poorly calibrated, they may also entrench existing market positions: well-resourced providers invest in equipment, data infrastructure and quality improvement, while resource-constrained ones fall further behind.
