Objective: Physician pay-for-performance are gaining momentum as an approach to improve health care quality in the United States. The objective of this study was to show the beneficial effects of physician incentive programs for the treatment of diabetic patients as well as the potential for cost saving. Methods: Administrative claims data from a large regional health plan were used through the 2004-2005 time-frame. Diabetic patients age 18-75 with private health insurance coverage were included in the analysis. Multivariate Poisson regression was used to model the likelihood of diabetes-related hospitalizations between patients who were being treated by a physician participating in the incentive program and those that were not. Likewise, cost savings associated with diabetic patients treated by physicians participating in the incentive program was also computed. Results: Over a two year period, patients in the P4P program showed a lower combined predicted number of hospitalizations (0.31) than that of patients not in a P4P program (0.39). In addition, cost benefit analysis using decision tree modeling showed the costs of the P4P program was entirely covered by the reduction in cost resulting from decreased hospitalization rates. With the incentive program, the health plan saved approximately $24 per adult diabetic and a total cost savings of $675,000. Sensitivity analysis shows that the higher quality of care resulting from the incentive based programs directly benefits outcomes of diabetes patients with an added benefit of reducing program cost. Conclusion: The cost savings associated with physician pay-for-performance programs depend highly on the effectiveness of the program to improve delivery of quality care. Physician incentive programs have the potential to improve patient outcomes as well as lead to economic benefits for payers.