Buying efficiency: Optimal hospital payment in the presence of double upcoding

Background: With DRG payments, hospitals can game the system by 'upcoding' true patient's severity of illness. This paper takes into account that upcoding can be performed by the chief physician and hospital management, with the extent of the distortion depending on hospital's internal decision-making process. The internal decision making can be of the principal-agent type with the management as the principal and the chief physician as the agent, but the chief physicians may be able to engage in negotiations with management resulting in a bargaining solution. Results: In case of the principal-agent mechanism, the distortion due to upcoding is shown to accumulate, whereas in the bargaining case it is avoided at the level of the chief physician. Conclusion: In the presence of upcoding it may be appropriate for the sponsor to design a payment system that fosters bargaining to avoid additional distortions even if this requires extra funding.