Abstract
We study physician agency and optimal payment policy in the context of an ex-pensive medication (epoetin alfa) used with dialysis. Using Medicare claims data we estimate a model of treatment decisions, in which physicians are partially altruistic and value both their own compensation and their patients’ health. We then use the recovered parameters of the model in combination with contract theory to derive and simulate optimal linear and nonlinear reimbursement schedules. Physicians differ in their marginal costs of treatment, and this heterogeneity is unobservable to the govern-ment, which affects payment policy, along with physician altruism and the effectiveness of treatment. Comparing outcomes under these optimal contracts against those ob-served under the actual contracts suggests that substantial improvements in payment policy can be achieved within a fee-for-service framework.

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