This study explores incentives and performance in organizations governed by publicly elected boards of directors and subsidized by taxes. Such organizations are likely to underpay Chief Executive Officers (CEOs), resulting in selection and incentive problems and hence poor operating performance. We compare municipal district hospitals to private nonprofit hospitals. CEO compensation in district hospitals is significantly lower than in the nonprofits. Operating margins in district hospitals are lower and deteriorate more rapidly over time. We rule out a number of other factors that could explain differences in performance. We conclude that the weak governance structure hampers district hospitals.

After 1983, Medicare paid hospitals for inpatient services at fixed rates, but continued to reimburse outpatient services based on reported cost. Using data from Washington State we find that hospitals responded by increasing outpatient services to Medicare patients compared to non-Medicare patients-the ratio of Medicare outpatient revenues as a percentage of total Medicare revenues increased after 1983 to a significantly greater extent than for non-Medicare patients. We also find that allocations of overhead costs to outpatient departments increased after 1983. These findings suggest that hospitals change their patient mix and cost allocations to maximize hospital cash flows.