Average cost

An average cost is a cost reported per unit. Health economists frequently use various average cost estimates, for example, the cost of treatment per patient, the cost of treatment per day or the cost of a drug per millilitre (mL). The average cost by mL can be calculated for a drug delivered as an oral solution. If a bottle contains 200 mL and costs £400, the average cost per mL is the total cost of the bottle divided by the number of mL, which in this example would equal £2/mL.

Although the average cost is a useful estimate of the value of inputs, health economists prefer to use the incremental cost as a standardised measure to compare cost-effectiveness of one treatment against another.

Cost-benefit analysis

Cost-benefit analysis (CBA) is an economic evaluation to inform decisions across several systems, such as government departments. For example, environmental policies can affect decisions across different bodies, such as the Department of Health or the Department for Transport.

CBA can be used to assess the cost and the benefit of an intervention in monetary units, i.e., a currency such as the pound sterling (£). Non-monetary benefits are assigned a monetary value based on their market price, when available; alternatively, the value is estimated based on the user’s willingness to pay. For example, fresh air affects population health, but it has no market price. Therefore, the value of fresh air is estimated based on the greater healthcare costs that ensue when pollution reduces the supply of fresh air and thereby increases the incidence of asthma. In this example, a CBA might compare the costs of improving air quality against the healthcare costs that would arise if air quality were lower.

Healthcare systems tend to have more limited resources than other sectors of the economy, which implies greater costs of reallocating resources, such as from one disease area or intervention to another. These opportunity costs must be considered when performing cost-effectiveness analyses in health technology assessments.

Cost-effectiveness analysis

Cost-effectiveness analysis (CEA) informs decisions about the allocation of limited resources across the healthcare system. It is used to make justifiable choices based on the best evidence available.

Generally, through economic modelling, CEA compares the costs and effects of alternative interventions. For example, a new health intervention is compared to the current intervention of choice. Outcomes are estimated using generic measures of health, such as quality-adjusted life years.

Figure 1. Cost-effectiveness grid to support cost-effectiveness analyses in healthcare

Figure 1 shows a cost-effectiveness grid illustrating how CEA informs choices among mutually exclusive alternatives provided to the same patient or group of patients. Comparisons are not always straightforward, because alternatives offer different costs and effects. For example, a treatment in the lower right quadrant is clearly an optimal choice because it is less costly and more effective than the alternatives. Simultaneously, a treatment in the upper left quadrant is clearly an inferior alternative because it is more costly and less effective than the alternatives. However, further analysis would be needed to determine whether treatments in the lower left or upper right quadrant can be recommended.

In the United Kingdom, the cost-effectiveness of a proposed treatment must be analysed, along with clinical efficiency, quality, and safety, before the treatment can be considered for market access or for reimbursement by the National Institute for Health and Care Excellence (NICE).

See cost-benefit analysis for an example of economic evaluation that can be used outside of the healthcare system.

Cost-effectiveness threshold

Healthcare budgets are fixed. This implies that approving a new treatment for reimbursement will reallocate resources and curtail supplies and/or services elsewhere in the healthcare system. This is explicitly represented as a cost-effectiveness threshold, also referred to as an opportunity cost. This threshold reflects the resources that the decision-maker is willing to spend on one unit of health outcome gained from a new intervention.

In the United Kingdom, the cost-effectiveness threshold is between £20,000 and £30,000 per quality-adjusted life year gained. This means that the National Institute for Health and Care Excellence (NICE) is unlikely to recommend a treatment if its extra cost per extra unit of health outcome, a quantity also known as the incremental cost-effectiveness ratio, exceeds the threshold. The threshold is defined to strike a compromise between encouraging pharmaceutical innovation and ensuring fair and equitable access to healthcare. Many researchers are currently exploring the best way to determine the cost-effectiveness threshold.

Health state

Also referred to as health status, the health state indicates to which category an individual belongs in a particular health economic analysis. For example, people can be “healthy”, “sick” or “deceased”. As disease progresses, patients move from one health state to another (Figure 1) and estimating or predicting such transitions draws on evidence from clinical trials. An effective intervention will move a patient from a health state of “sick” to a state of “healthy”. However, patients may also remain in the same health state for prolonged periods of time.

Assuming there are three health states that individuals can progress through (downward arrows), or remain within (circular arrows), a health intervention can help the sick return to a healthy state.

Figure 1. Disease progression as modelled by health economists

Health outcome

Also called a health output, a health outcome refers to the health effect produced by a healthcare intervention. Accurate measurement of health outcomes is key to evaluating the cost-effectiveness of treatments and defining best practises. However, such measurement is complex. The most appropriate outcome must first be defined, and this depends on the disease or condition. For example, knee surgery is expected to improve knee swelling while anti-epileptic medication is expected to reduce seizure frequency. Often, one health outcome is not enough to provide a complete picture, given that health interventions are likely to have multiple effects. For example, measuring only mortality may miss important benefits or costs to patients’ quality of life. Therefore, cost-effectiveness analyses increasingly rely on quality-adjusted life years.

During health technology assessments, multi-dimensional measures of health outcomes that can be compared across disease states or patient populations are usually preferred (see quality adjusted life years [QALYs]).

Health economics

Purchasers of healthcare, such as national health services or insurance companies, have a limited budget and therefore may use health economics to optimise how they allocate their resources.

Every decision within a budget-constrained healthcare system reallocates resources, so health economics means comparing the costs and effects of such reallocation to ensure that gains are likely to outweigh losses in another area. One of the more frequent applications of health economics is cost-effectiveness analysis.

Topics in health economics include, for example:

  • Producing and delivering health goods and services,
  • Measuring health states and performing economic evaluations,
  • Undertaking health technology assessments,
  • Predicting health behaviours, and
  • Defining health insurance reimbursement schemes

Health economics originated in the United States with the publication of Kenneth Arrow’s article “Uncertainty and the Welfare Economics of Medical Care” in 1963. The discipline subsequently developed in various countries, leading in the United Kingdom to the creation of the National Institute for Health and Clinical Excellence (NICE) in 1999.

Healthcare system

Also referred to as a health system, a healthcare system has as its core objective the delivery of goods and services as well as the allocation of limited resources to meet the health needs of a population. Additional objectives of healthcare systems may include, for example, preventing and controlling communicable diseases, treating illnesses, and promoting healthy behaviours.

Although healthcare systems around the world may share similar objectives, each system differs from others in how it is funded, who can access its goods and services, and the types of goods and services that it provides (Table 1).

These systems make use of different funding strategies to protect individuals from the uncertainty of healthcare needs. Public funding, for example, means that the healthcare system is financed through taxation; this also means that any increase in funding requires reallocation of public revenues away from other public goods and services. In the United Kingdom, for example, the Parliament decides the NHS expenditure along with the financing of other sectors. Private funding means that individuals must contribute to an insurance plan or pay out-of-pocket. In the UK voluntary private insurance can be purchased to cover certain healthcare needs or reduce waiting times for certain goods and services.

Universal health coverage is one of the sustainable development goals set by the World Health Organization. This goal means providing adequate access to healthcare of all populations without creating financial hardship for them.

Table 1. Examples of different types of healthcare system*

*The healthcare systems in this table are representative of most countries in the Organisation for Economic Co-operation and Development, which are considered to be high-income, developed countries.

**8.5% of the population uninsured in 2018 as reported in Bohm et al. (2013).

Table sources: Bohm et al. (2013) and Commonwealth Fund (2020)

Health technology assessment

Also referred to as a health technology appraisal, a health technology assessment (HTA) aims to guide the allocation of healthcare resources and inform reimbursement decisions. It assesses the clinical effectiveness and cost-effectiveness of a new intervention, in comparison with alternative interventions.

Each HTA is supported by economic evaluation, which estimates how resources should be allocated to maximise overall utility, and by clinical evidence on the safety, efficacy, and quality of the treatment.

An HTA includes:

  1. A definition of the evaluation scope,
  2. A systematic review of the clinical and economic evidence,
  3. An estimation of the cost-effectiveness, usually via economic modelling,
  4. An interpretation of the results to inform justifiable healthcare recommendations.

To ensure the information is presented consistently and appropriately to HTA bodies, HTA proposals are usually structured based on a “reference case”, which in the United Kingdom is provided by the NICE manual.

Incremental cost

Incremental cost is the additional cost of a treatment compared to an alternative, i.e., the cost difference between them (Table 1). Incremental costs are used in cost-effectiveness analyses of alternative treatments to estimate the incremental cost-effectiveness ratio (ICER).

Table 1. Example of a pairwise incremental cost calculation

Incremental cost-effectiveness ratio

During cost-effectiveness analyses, a summary measure representing the economic value of an intervention relative to an alternative intervention is calculated. That summary measure is the incremental cost-effectiveness ratio (ICER). The ICER is the ratio of expected additional total cost (also called the incremental cost) of one intervention to its expected additional effect (also called incremental effect), all with respect to an alternative intervention.

The ICER is calculated as follows:

The ICER can then be used to estimate quality-adjusted life years associated with the proposed intervention.

(This ICER is not to be confused with the Institute for Clinical and Economic Review, a health technology assessment organisation in the US whose name is frequently abbreviated to ICER.)

Marginal cost

Marginal cost is the extra cost of providing an additional unit of care, and this extra cost can be measured in whatever terms may be most relevant for the situation. For example, marginal costs may be calculated in terms of each additional patient or of each additional year of follow-up.

Table 1 illustrates an example of marginal costs for a situation in which surgery on one patient costs £12,000, and each year of follow-up costs £4,000 as presented in . In this case, the cost in year 1 is the sum of the cost of surgery and one year of medical follow-up, the cost in year 2 is the sum of the cost of surgery and two years of follow-up, and so on. In this example, marginal costs are constant from year 2 onwards, reflecting the fact that surgery costs occur only in year 1, while follow-up costs occur each following year.

Table 1. Marginal cost

Opportunity cost

Healthcare budgets are limited, and the adoption of a new health intervention affects the rest of the system: adding resources to one part of the system means reducing them in another. The opportunity cost refers to the health effects that are “lost” when a less effective intervention is chosen instead of a more effective one. Table 1 provides a simple example, in which treatments A, B and C all have the same financial cost, yet they differ in health effects. Choosing treatment A over treatment B has an opportunity cost of 1 unit of health effect, while choosing treatment C over treatment B has an opportunity cost of 2 units.

Table 1. Cost and effect data for three alternative health interventions

Treatment Cost Unit of health effect
A £1000 3
B £1000 4
C £1000 2
Quality-adjusted life years

Quality-adjusted life years (QALYs) are currently considered the most appropriate generic measure of health benefit, according to the manual of the National Institute for Health and Care Excellence (NICE) in the United Kingdom. QALYs can be compared across diseases areas and healthcare systems.

In a single number, QALYs capture the extent to which a treatment prolongs or increases the quantity of life (reduced mortality) and the quality of life (reduced morbidity). QALYs measure multiple dimensions of health outcomes: each health state is described using the five dimensions of mobility, self-care, ability to carry out usual activities, pain/discomfort, and anxiety/depression. Figure 1 illustrates how three alternative treatments may affect the quantity and quality of life. Treatment A offers a shorter quantity and lower quality of life than treatment C. Treatment B offers shorter quantity but higher quality of life than treatments A and C.

How quality of life is calculated depends on the context: the NICE manual, for example, recommends weighting health states according to the preferences of the target population. Thus, for a population that prefers longer life to healthier life, QALYs would be higher for treatments A and C than for B. The converse would be true for a population that prefers healthier to longer life.

Figure 1. Quality and quantity of life of treatments A, B, C

In health economics, a given intervention is associated with a certain number of quality-adjusted life years, a measure that adjusts the quantity of life after that intervention (survival years) by the quality of life after the intervention (weight).

QALYs are computed in several steps:

  1. Description of the dimensions of outcomes of interest (i.e., what should count?),
  2. Estimation of health states from clinical evidence,
  3. 3. Valuation of each health state using generic preference-based measures of health,
  4. Discounting of the individual utility scores,
  5. Multiplication of the duration of time spent in each health state by the weight estimated in step 2 and aggregation of these utility scores within a time horizon. QALYs range between 0 and 1 for states equivalent to death and full health, respectively.

In the United Kingdom, NICE considers QALYs as the most appropriate measure of mortality and morbidity. In the United States, the Institute for Clinical and Economic Review recommends the use of QALYs as well as other measures of health outcomes, such as Equal Value of Life Years Gained (evLYG).

Quality of life and health-related quality of life

Quality of life in general refers to the well-being of a person or population, and health-related quality of life (HRQoL) specifically is a multi-disciplinary concept encompassing the physical, mental, and social well-being of a person. HRQoL is subjective because it describes both the health status of a patient and the value associated with that health status. The manual of the National Institute for Health and Care Excellence (NICE) in the United Kingdom recommends that HRQoL be assessed by patients and weighted according to the preferences of the general population. The HRQoL is then incorporated into calculations of QALYs in a cost-effectiveness analysis.

Real-world evidence

Real-world evidence (RWE) is clinical evidence about the benefits and risks associated with a medical device or drug, derived from the usage real-world data (RWD). RWD includes information about the patient health status or the delivery of health care outside of a clinical trial setting and could be routinely collected from a variety of sources such as electronic health records, wearable devices, medical claims, or patient registries.

Total Cost

The total cost of an intervention is the sum of the resources used to deliver that intervention to a specified population over a specified period of time. Which costs are included in the calculation of the total cost depends on whether the analysis is performed from the perspective of society or the healthcare system (Table 1). For example, the total cost of an intervention to the healthcare system would not include costs to society or other sectors of the economy, such as the costs of travelling to the hospital or the loss of work productivity.

Table 1. Healthcare costs that may be included in the calculation of total cost of a health intervention, depending on the perspective from which “total cost” is defined

Total costs are calculated in market prices. They may also be treated as opportunity costs considering the finite resources of a healthcare system, which means that a shift to one intervention reduces resources available for another.


Healthcare systems must address diverse health conditions for diverse types of patients, yet their resources are limited. Utility is a concept that allows health economists to weigh or prioritise certain interventions according to what the target population prefers and considers fair. Utilities consider the trade-offs or opportunity costs that the target population must make to gain one unit of health benefit.

To build economic models, assume that utilities can be added over time and they use Quality-Adjusted Life Years (QALYs) to measure them as recommended by the National Institute for Health and Care Excellence (NICE) (See NICE Manual for further details).

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