There’s a story about the Indian city of Delhi that had a problem with too many venomous cobras. The ruling British government decided that enough was enough and finally the time had come to do something to control the snakes and so instituted a reward for every dead snake brought to officials.

In a wonderful example of the power of incentives, the Indian population dutifully began breeding venomous snakes to kill and hand over to the British. By the time the experiment finished, the snake problem was worse than it began.

Never underestimate the power of incentives.

It happened in Australia’s vocational education sector and we’ve seen the results with both Vocation Ltd and Australian Careers Network filing for administration, while others have struggled to remain going concerns.

Unfortunately, investors in Australia’s aged care sector have also experienced just that.

Government funding

The way the government pays the providers is through the Aged Care Funding Instrument (ACFI). The funds are calculated per resident, per day, based on how well the resident can look after his or her self. Currently, the ACFI subsidy is worth around $36 per day for low-care residents and as much as $108 a day for high-care patients.

If a person needs a higher level of care, then the aged care provider claims more from the government. That might make logical sense, but it has opened up the system for abuse.

This is not the first time the sector has been called out for rorting the system either. In 2012, Department of Health and Ageing whistleblowers told the ABC that aged care providers were rorting government payments to prop up their profits rather than provide care for their residents. There were claims of falsely classifying their residents as high care when the providers aren’t actually providing any extra services.

At the time, the government was spending more than $7 billion in residential care for elderly Australians. In 2016-17, that is estimated to be $17.8 billion.

Earlier this year, a survey found that aged care home profits had surged by 40% in the past year. And the Minister for Aged Care, Sussan Ley revealed that 1 in 8 of the 20,000 claims audited in 2014-15 were deemed to be incorrect or false, and in 2015-16 it was tracking at 1 in 7.

In response, in May this year, the Federal government announced that it was introducing fines of $10,800 for every false claim, and was also halving the indexation rate for claims under the Complex Health Care part of the ACFI – saving the government $1.2 billion over 4 years.

Soaring ACFI claims

The three ASX-listed companies in the firing line are Japara Healthcare Ltd (ASX: JHC), Estia Health Ltd (ASX: EHE) and Regis Healthcare Ltd (ASX: REG).

Japara recently reported that it has increased its average ACFI by 3% from $179 to $184.39 per resident, per day in just 6 months to end of December 2015. A year ago it was $170.81 and in the first half of FY 2014, it was $166.84.

In April this year, Estia Health highlighted a recent acquisition where it increased its ACFI per occupied bed from $164 a day to $178 a day post-acquisition, and another from $141 per day to $184 a day. The aged care provider also said it was “improving financial performance through increasing occupancy and ACFI whilst reducing staff costs / agency costs”.

Risks

The incentives are clearly there for aged-care providers to increase the ACFI funding they receive, whilst also cutting their staff costs. But how do they do that while increasing care to justify the increased ACFI?

There’s also the incentive for the aged care providers to overpay for acquisitions in the hope of increasing the average ACFI once they have control of the home.

Foolish takeaway

While the problems in the aged care sector are unlikely to see any of the major operators run afoul of the government and have their funding slashed dramatically, it is a risk nonetheless.

What is a risk is that the government further tightens its funding for aged care – affecting all operators in the sector – and potentially causing some that are over-leveraged to topple.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.