Why do people go across town to save $10 on a clock radio but not to save $10 on a large-screen TV? After all, the same amount of money can be saved in both cases.
The explanation for the difference in behavioral response in these two scenarios is called the principle of “diminishing marginal utility” (Lowenstein, 2001): the perceived value of a sum of money becomes progressively lower when associated with an increasingly larger sum of money. Thus, for example, an individual perceives the difference between $0 and $10 as being greater than the difference between $100 and $110, which is perceived as being greater than the difference between $200 and $210, and so on. This principle asserts that people tend to judge such gains or losses as changes from their current state of well-being (or reference point), rather than their final states (Kahneman and Tversky, 1979).
When we apply these findings to hospital P4P program design, it may be more psychologically motivating to provide smaller, more-frequent incentive payments than to provide a larger, lump-sum incentive payment. As an example, consider that a total of $1,000 in incentives is to be provided to a hospital based on its performance. According to the principle of diminishing marginal utility, the hospital’s behavioral response is likely to be greater if the $1,000 is divided into a number of payments—say, ten payments of $100 each—rather than paid as a lump sum. The reason for the greater motivation is that each $100 is perceived as a new $100 gain, capitalizing on the steepest portion of the utility function (the difference between $0 and $100), rather than simply as an addition to the previous gains (for example, from $500 to $600) (Thaler, 1985).
One way to structure this type of incentive in a P4P program would be to link the incentive payment to each applicable hospitalization. For example, the hospital could receive an extra payment of $100, on top of its usual DRG payment, for every patient admitted for pneumonia that received the care designated by the quality measure(s). This approach could lead to a greater behavioral change by the hospital than if it were to receive a lump sum, equal in dollar value, at the end of the year.