In many developing countries, public patients offer payments to their doctors outside the official payment channels. We argue that the fundamental reason for these informal payments is that formal prices cannot fully differentiate patients' various needs. We compare patient welfare and social efficiency when informal payments are allowed with the scenario when they are banned. Patient heterogeneity plays a central role in the comparison. Contrary to conventional wisdom, allowing informal payments always improves social efficiency when patients do not face income constraints. Moreover, allowing informal payments improves patient welfare if patients' willingness to pay differs significantly.
