Patients with health insurance do not make the most cost conscious healthcare decisions since they bear only a fraction of the total cost of medical care. Managed care advocates point to financial incentives as a way to reduce wasteful resource use. However, physicians with managed care contracts feel financial pressures designed to reduce waste may also limit medically necessary services and adversely impact the quality of patient care. In light of a growing public and professional distrust of the motives behind offering financial incentives, the economic theory of agency is used to illustrate how financial contracts designed to reduce wasteful resource use influence physician behavior.A review of the literature was conducted to determine the effects of financial incentives on resource use, cost and the quality of medical care. The method used to undertake this literature review followed the approach set forth in the Cochrane Collaboration handbook. This review revealed that much of the empirical evidence on the effect of managed care on physician behavior compared the experiences of traditional indemnity plan enrollees with health maintenance organization enrollees.Published studies are outdated and are influenced by statistical problems including both patient and physician selection bias. With respect to the newer types of managed care organizations, there is a paucity of information on the effects of financial incentives on physician behavior. Despite the lack of empirical evidence, the perception remains that managed care financial incentives are perverse in that they induce physicians to take actions that compromise quality of care. To evaluate the legitimacy of these concerns, research on how physician contractual arrangements influence the cost and quality of care in the newer types of plans is needed. In the absence of such research, political rhetoric bent by anecdotal evidence will continue to influence public policy and undermine managed care.