Avoiding free riders

Thomas Flannery and Bill Dixon both are senior client  partners and co-lead the firm’s Health Care - Executive Pay and Governance practice.

It’s the first—and second—thing you hear. When it comes to incentive compensation plans in the health care business, board members and CEOs tend to cite two issues: “free riders” and overly complex plans.

A free rider is someone who benefits from an incentive plan without really contributing at the expected level as others. This problem is endemic in executive compensation plans, be they in publicly traded organizations where awards are based on share price or other macro financial metric, or in a tax-exempt health care organization where awards are based on corporate results like bond rating, margin, or a strategic/qualitative metric.

Most health care executive incentive plans focus on three levels of results: organization-wide (corporate), unit, and individual. Programs designed in the last part of the 20th century primarily emphasized corporate results, the logic being: “we are all in one system.” These have been referred to as “kumbaya” plans. Some variation in plan design offered some opportunity for differences in payouts at the unit and individual levels, but often they are a small percentage of the overall plan awards.
A health care organization recently asked us to assess the return on investment provided by its plan. We conducted in-depth interviews with vice presidents, directors, and department heads at this high-performing specialty health care organization to assess participants’ satisfaction with the current incentive plan and to posit possible changes.

An overwhelming number of participants said they were happy with the current plan. But digging deeper, and we discovered that at levels below the CEO and his reports, most participants felt they have no ability to directly influence clinical, financial, or operational outcomes. They expected the CEO and CFO to find ways to make the incentive plan pay out. The plan morphed from being an incentive plan to being an entitlement plan. In short, they were satisfied with the plan for the wrong reason: it was rewarding free riders.

When we asked how the incentive plans could improve, many felt that their performance could be better measured at the unit and individual levels, where they felt more control and ownership. Were they willing to accept change? While not happy in some ways, they recognized the inevitability of it, and it was more positive having to be measured with a more direct line of sight to their accountabilities.

As for plans being too complex, health care organizations, until relatively recently, were not able to measure performance below the corporate level effectively. Data systems were not sufficiently robust to track performance reliably and promptly. With new enterprise and clinical systems, however, this has changed. Effective real-time decision management is now much more attainable, with data that is valid, reliable, complete, and timely.

With new systems, it is now possible to improve line of sight for incentive plan participants significantly. A health care system with several hospitals, groups, and lines of business can now more effectively measure the performance of the local hospital executive’s contribution. This increase in complexity is worth implementing for two reasons: it improves ownership over results at all levels, and it enhances the return on investment for incentive plans.

By harnessing today’s electronic technology, health care organizations have the opportunity to build powerful incentive plans that reflect unit and individual performance, thereby improving organizational performance and accountability.