Here's a pretty good take on free agent compensation from U.S.S. Mariner: 

Seriously, when you stop and think about how the system works and the results it provides, everyone loses. They’re bad for everyone, and it’s pretty remarkable that they still exist. Let’s look at what they’re supposed to do and what they actually do.

Goal #1: Promote parity by allowing teams to recoup talent lost when big market teams steal their players

This clearly doesn’t happen. Go through the list of who gets compensation picks every year, and it’s not the Marlins, Rays, and Royals. It’s the Yankees, Red Sox, and Dodgers, plus other similar big payroll teams. There’s a couple of reasons for this:

1. Type A and Type B free agents are generally good players. Good players make a lot of money, so they are more likely to be on teams with big payrolls. When their contracts expire and they sign with a new team, they’re generally just going from one big payroll team to another, and so the big boys who certainly don’t need extra picks for competitive balance reasons end up with an advantage in the draft anyway.

2. The system requires you to take a financial risk in order to get the draft pick. Teams on strict budgets can’t always afford to take the risk that a player will accept arbitration and eat up a big chunk of their payroll, but it’s just not a big deal to the Yankees if Damaso Marte makes a couple million more than they were counting on. The big payroll teams are more able to take the risk, and thus, more likely to get the reward.

Goal #2: Provide a disincentive for teams to sign free agents away from other clubs, making it more likely for players to stay with their original franchise.

Again, it clearly doesn’t work this way. If you lose a Type A free agent (and you offer them arbitration), you get two high draft picks. If you sign a Type A free agent that another team had offered arbitration to, you lose one high draft pick. In many cases, you actually get rewarded for letting your player leave and bringing in someone else’s exact equal. For instance, if the Mariners were to have to decide between re-signing Raul Ibanez this winter or offering the exact same contract to say, Pat Burrell, then they’d gain an extra pick from signing Burrell and letting Ibanez leave. In fact, we’ve seen teams essentially swap free agents at the same position and both teams have come out with +1 draft picks - the Orioles and Rangers did this in 1994 with Rafael Palmeiro and Will Clark.

Those are basically the two overriding goals of free agent compensation, at least in theory. The current system fails spectacularly at both, and just for good measure, has even more flaws as a byproduct of the system.

MLB free agent compensation