This paper discusses policy issues faced by two-year colleges in the state of Washington during the first year of implementation of performance funding. Four key policy questions were reviewed: (1) the reward versus entitlement paradigm shift, which forces educators to alter expectations about "entitlement" to higher education funding and accept allocation based on performance; (2) state versus local priorities that can cause conflicts between state-level approaches to performance and autonomy at the college or district level; (3) whether performance funding motivates colleges to improve performance; and (4) what happens when performance funding results in reallocation of resources away from nonperforming institutions. In Washington state several practical difficulties were encountered in designing the performance funding system for the state's community and technical colleges. They included complexity, timeliness problems, and the problems inherent in a funding system based on unstable, quantitative indicators. Despite these problems, the first year of performance funding resulted in new understandings of student development and highlighted areas of the system that needed improvement. An excerpt from a report on performance-based funding by Brenda Norman Albright focusing on strategies for using performance measures and outlining key principles is appended. (CH)