Employees are divided into grades. Toyota places suppliers into only a small number of categories. This paper shows that grouping of privately informed and persistent agent types arises naturally in relational incentive contracts when agent type is continuous. Malcomson (2016) showed that full separation is not possible if, following full revelation of an agent’s type, payoffs for principal and agent are on the Pareto frontier. This paper shows how much separation can be achieved. Specifically, it characterises the finest partitioning that can be achieved in each period with agent types for which first-best effort is unattainable. Separation may take time, with initial coarser partitions being subsequently refined, but does not continue indefinitely. When it stops, there remain a finite number of groups of agent types. Numerical illustrations for constant elasticity cost of effort show the maximum number is typically small despite agent type being continuous.
