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As a novel supporting approach, performance-based contracting (PBC) ties the service supplier's compensation to the performance outcome of the system owned by the customer. It enables the service supplier to implement an effective maintenance and spare parts inventory policy so as to improve system performance. In this paper, we propose a principal–agent modeling framework for deteriorating production systems operating under PBC, with the objective of maximizing the expected utilities of both stakeholders. The customer (principal) offers PBC with a fixed payment plus performance incentive form to the service supplier (agent), who in turn implements a condition-based maintenance (CBM) policy based on the system prognostic condition at periodic inspections, and sets an investment level of spare parts inventory. Considering the partial observability of the service supplier's actions, the optimal combination of performance incentive in PBC provided by the customer, and the joint CBM and spare parts inventory policy implemented by the service supplier, are determined through a two-stage and heuristic approach. Finally, a numerical example and sensitivity analysis based on a real-world scenario are presented to illustrate and verify the applicability of the proposed model. • Investigate the performance-based contracting (PBC) for degrading production systems. • Analyze condition-based maintenance (CBM) and spare parts inventory policy. • Propose a principal–agent model and a two-stage solution approach. • Determine optimal PBC incentive, joint CBM and spare parts inventory policy. • Verify the applicability of the proposed model. [ABSTRACT FROM AUTHOR]