["Journal of Economics &Management Strategy, EarlyView. ", "\nABSTRACT\nIn this paper, we investigate the contracts offered by a large healthcare purchaser to health service providers. Contracts are based on the DRG principle that all hospitalizations in a diagnosis group are reimbursed at the same rate. This principle is relaxed in practice, as in several cases, the amount reimbursed within each DRG exhibits considerable variability. We build a theoretical model which explains this variability as the attempt of the health authority to ensure appropriate matching between hospitals and patients. We test the model using a very large and detailed administrative data set for the largest region in Italy. In line with our theoretical results, we show that the state funded purchaser offers providers a system of incentives such that, as required by optimality, that providers which treat more patients receive a higher average reimbursement per treatment, suggesting therefore that they treat on average more difficult patients and are compensated for doing so.\n"]