Incentivizing Physicians' Diagnostic Effort and Testing With Moral Hazard and Adverse Selection

ABSTRACT We analyze a setting in which physicians, who differ in their degree of altruism, first exert diagnostic effort before deciding whether to administer a test to determine the most appropriate treatment. Diagnostic effort yields an imperfect private signal of the patient's type, whereas the test provides a more accurate assessment. Absent corrective transfers, physicians exert too little diagnostic effort and may rely excessively on testing. When altruism is either homogeneous or observable, the first‐best allocation can be decentralized through a payment scheme consisting of (i) a pay‐for‐performance (P4P) component, based on the proportion of correctly treated patients, to induce the optimal diagnostic effort and (ii) a fixed component to ensure both the optimal testing decision and physician participation. When altruism is heterogeneous and privately known to physicians, the two‐part tariff that decentralizes the first‐best is no longer incentive compatible. The optimal contract is pooling rather than separating, an instance of nonresponsiveness. Its uniform P4P component induces more altruistic physicians to exert higher diagnostic effort, while the fixed component must be conditioned on diagnostic test costs to promote optimal testing decisions.