The design of a contracts payment structure can affect the public agency and the contractor in at least four broad ways:
- Providing incentives to perform and the potential for unintended consequences
- Changing the distribution of the risk between public and private agencies
- Affecting the contractors cash flow
- Presenting operational challenges of administering the contract
The implications of each contract type are summarized in Table IV.3.
|Contract Type||Strength of Incentives||Risk||Cash Flow Problems||Operational Challenges|
|Pure pay-for-performance||High||Contractor bears most||Can be significant||Requires performance data
Setting targets and payment amounts
|Cost reimbursement||Low||Welfare agency bears most||Less significant||None|
|Fixed price||Low||Divided between welfare agency and contractor||Less significant||Setting fixed price|
|Hybrid||Moderate||Divided between welfare agency and contractor||Less significant||Requires performance data
Setting targets and payment amounts
Incentives. Pure pay-for-performance contracts offer the most financial incentives for contractors to meet performance goals. These contracts also allow the public agency to place emphasis on specific goals by varying the dollar amounts attached to attaining each goal.
Evidence from the study sites suggests that these incentives do motivate contractors. In the organizations with pay-for-performance contracts visited as part of the study, all staff members, from the top management to the front line, were aware of the performance goals and their importance. Progress on goals was communicated frequently through meetings and process reports. In some organizations, case managers received individual performance targets and progress reports. At least one for-profit contractor pays its case managers bonuses based on their individual contribution to meeting contract goals. Some contractors even provide clients financial incentives that are linked to performance goals. For example, in Delaware, one contractor provided a $20 incentive for clients to enroll in its program.
Even when payments do not depend on performance, as in cost-reimbursement and fixed-price contracts, contractors care about their performance, especially if the contracts include performance measures. Measured performance can affect whether contracts are extended and which providers are selected at competitive procurements. It may also affect contractors reputations as providers and hence their likelihood of being retained by other agencies.
The incentives to perform in cost-reimbursement and fixed-price contracts are, however, less intense than those in pure pay-for-performance contracts. In Hennepin County, which uses a cost-reimbursement contract, contractors were not as intent on attaining all the performance goals as contractors in sites with pay-for-performance contracts. One provider, for instance, places special emphasis on enrolling clients into education and training, in order to achieve better wages for its clients, but does not meet its employment target.
The unintended incentives associated with performance measures are magnified when payments are based on attainment of the goals. However, the potential for unintended incentives exists in all contracts, even those without performance standards. In cost-reimbursement contracts, contractors have the incentive to provide clients with services even if it is not cost-effective to do so. In fixed-price contracts, an incentive exists for contractors to cut costs by not serving clients or by serving them with a "light touch."
The first contract used in Wisconsin for the provision of TANF services provides an example of the potential for serious unintended incentives. The contracts were cost-reimbursement but included a bonus that depended on the difference between actual costs and a specified maximum. If costs exceeded the maximum, the difference was the responsibility of the provider. If the provider spent less than the cap, however, it received a portion of the savings. Critics of the contract argued that it gave contractors the incentive to not serve clients or serve them less intensely. The contract generated substantial controversy when large caseload reductions in Wisconsin resulted in significant profits for the providers in one case, more than $9 million. The criticisms of the contract led the state to completely overhaul its bonus provisions.
Public agencies can take several steps to reduce the potential for unintended incentives. Adding performance standards to the contract without tying them to contract payments is one common way to do so. For example, in Palm Beach Countys fixed-price contract for eligibility determination, the performance measures include high targets for the quality of case processing, including client satisfaction, timely actions, and accurate processing. These standards guard against contractors attempting to reduce costs and compromising quality in the process. Capping payments on cost-reimbursement contracts discourages frivolous spending.
Distribution of Risk. The cost and effectiveness of providing TANF services is uncertain. The number of clients and the ease with which they can be moved toward self-sufficiency is unknown and difficult to forecast accurately. The payment structure in contracts affects how the risk associated with this uncertainty is distributed between the public agency and contractors.
Pure pay-for-performance contracts are the least risky contracts for public agencies and the most risky for service providers. Payments only occur if contractors are successful at meeting the performance goals. The amount to be paid is usually capped, limiting the financial risk to the public agency. In contrast, there is no minimum payment to the contractor payments depend only on success at meeting performance goals. This success depends at least partly on factors outside of contractors control, however, such as caseloads, the economy, the availability of support services, and the barriers to employment faced by their clients.
Pay-for-performance contracts are most risky if payments are based on the number, rather than the percentage, of clients who meet performance targets. This is because under these contracts payments are dependent on referral flows. A shortfall in referral flows can significantly lower payments. In Delaware, the number of clients referred to contractors providing retention services had been lower than expected around the time of the site visit. Because payments were based on individual clients achieving milestones, the drop in referrals had significant effects on some providers income. At least one nonprofit contractor was contemplating layoffs.
Under cost-reimbursement contracts, most of the risk is borne by the public agency. These contracts require payments to be made even if services are of poor quality or ineffective. The public agency also bears the risk of changes in referral flows, paying more if caseloads rise, and sometimes paying for the increase in the cost per client as caseloads fall. Cost-reimbursement contracts usually include a cap on total payments to the contractor to limit the financial obligations of the public agency.
Under fixed-price contracts, the public agency and contractor share the risk. These contracts are risky for the public agency because they require payments to be made irrespective of the quality and effectiveness of the services. But because the amount paid is fixed, the contractor bears the risks of higher than anticipated costs because of referral increases, higher service costs, or increased client needs.
It may not be in the best interests of the public agency to design contracts that are risky for contractors, for two reasons. First, if contractors are suffering financially, they may end up either cutting costs or terminating the contract, both of which may have detrimental effects on service provision. Second, smaller organizations with limited financial resources may be less likely to bid for risky contracts, reducing the diversity of service providers and the extent of competition. This is one of the main reasons for the cost-reimbursement contracts in Hennepin County, where the public agency prioritizes cultivating community-based providers that have experience serving distinct client populations.
By dividing a contractors total payments between performance-based compensation and cost-reimbursement or fixed payments, hybrid contracts allow agencies to retain incentives for providers while sharing the risk. San Diego County first used a cost-reimbursement contract but switched about a year later to a pure pay-for-performance contract. When the county revised its performance targets some months later, it also incorporated a fixed payment into its contracts in order to moderate the risk borne by contractors. An interesting feature of this arrangement is that contractors can choose (within bounds) the amount of their compensation received as a fixed payment, tailoring the individual contracts to their willingness to bear risk.
Some contracts include clauses that allow reconsideration of the payment structure if there are significant changes in the economy or referral flows. In San Diego, for example, the contracts include a guarantee that the county will meet with the contractors to re-evaluate performance goals if the unemployment rate deviates by more than 2 percent for two consecutive months from a specified rate or if caseloads are more than 5 percent above monthly projections for two consecutive months. In Delaware, some contracts have included a sliding fee scale in which the payment per client increased if there was a decline in referrals. In Palm Beach County, if the quarterly client flow varies from the forecasted number by more than 15 percent, either the contractor or the public agency can request a reconsideration of funding.
Cash Flow. Contract design affects when payments are made to contractors, as well as how much they are paid. The timing of payments is important because it affects the financial resources needed for contractors to cover expenses before they are paid. Small organizations may not be able to bid on contracts that require them to have the financial resources to weather a period when expenses exceed income, even if it is relatively short. Public agency staff in Palm Beach County noted that availability of financial resources to cover upfront costs was an important factor in awarding its contracts. Lower Rio Grande Valley also was concerned about this issue after a contractor responded to cash flow problems by delaying supportive service payments to clients.
Pure pay-for-performance contracts do not pay providers until they meet a performance goal, which may occur many months after they have incurred the expenses of providing services for the client. Even with cost-reimbursement contracts, costs may not be reimbursed for several months after they are incurred. These problems are most significant for large contracts and at the beginning of the contract, especially if contractors are expected to run large programs or ramp up quickly to serve clients.
Public agencies in the study sites have addressed this cash-flow problem in several ways. Some have shied away from using pure pay-for-performance contracts. San Diego County switched to a hybrid contract after first using cost-reimbursement contracts and then pure pay-for-performance contracts. The public agency in at least one site, Wisconsin, makes advance payments to help contractors cover their initial costs, disbursing a fixed amount during the first three months of the contract. Other sites, such as Lower Rio Grande Valley, have been reluctant to make advance payments, citing the financial risk to the public agency. If a service provider became insolvent, the agency would be unlikely to recover possible substantial outlays.
Operational Challenges. Pay-for-performance contracts also present some operational challenges to the public agency. First, accurately assessing performance requires a sophisticated data collection system. Although this is a requirement for all contracts with performance measures, its importance is magnified when payment is based on performance. In San Diego County, the need to develop an adequate data management system delayed the change over from a cost-reimbursement to a performance-based contract by five months.
A second operational challenge is setting reasonable performance targets and payments for reaching the targets. If the targets are set too low or the payments too high, the incentives to perform weaken. Setting the targets too high or the payments too low also may have serious financial implications for the contractors. A similar challenge is how to set the payment amount in a fixed-price contract.
Several agencies reported encountering difficulty in setting reasonable targets, especially during the initial implementation of their TANF programs. Lacking historical data for their performance goals, sites were forced to rely on "educated guesses" about referral flows and the number of clients who are expected to meet the goals. These sites revised their performance targets or payments once they found the original targets were too high or too low.