One of the key issues in implementing prospective Medicare fee schedules is how to set prices that accurately reflect competitive market forces. Competitive bidding has long been used in government procurement efforts for nonhealth services. In this paper, we evaluate how provider behavior will be affected if Medicare uses competitive bidding to set Medicare fee schedules. Our model provides several important insights about competitive bidding for health care services. First, the model shows that competitive bidding will lead to 2-stage competition between providers. In the bidding stage, providers will compete to submit winning bids. In the following stage, winning providers will compete for business through marketing efforts that may enhance quality. Second, the model shows how the design of the bidding mechanism affects bidding strategies and the importance of individual provisions within the design, such as penalties for losing bidders. Third, the model demonstrates how competitive bidding will affect quality. It shows how quality may deteriorate if the bidding mechanism chooses an exclusive winner and why naming multiple winners can keep quality at acceptable levels. Finally, we identify criteria for determining whether a particular type of Medicare service is well-suited for competitive bidding.
