Chapter 2

Measuring and Estimating Costs

Course: PHARMACOECONOMICS (ECON407)

FALL : 2025-2026
Objectives
Upon completing this chapter, the reader will be able to:

1. Define different costing terms.

2. Categorize types of costs.
3. Determine the perspective of a study based on types of
costs measured.
4. Understand when adjusting for timing of costs is
appropriate.
5. Calculate net present value.
 Costing terms

Costs are calculated to estimate the resources (or inputs) that are
used in the production of a good or service.

According to economic theory, the “true” cost of a resource is its

opportunity cost—the value of the best-forgone option or the “next
best option”—not necessarily the amount of money that changes
hands.

The “price” or the amount that is charged to a payer is not

necessarily synonymous with the cost of the product or service.
 Cost Categorization
In the 1980s and 1990s, most textbooks categorized pharmacoeconomic-related
costs into four types:
 Direct medical costs
 Direct nonmedical costs
 Indirect costs
 Intangible costs
An alternative method of categorization has been recently proposed by
Drummond et al. that includes the following four categories:
o Healthcare sector costs
o Costs to other sectors
o Patient and family costs
o Productivity costs
 1- Direct Medical Costs
These are the medically related inputs used directly to provide the
treatment.

E.g.: Direct medical costs include the costs associated with

pharmaceuticals, diagnostic tests, physician visits,
pharmacist visits, emergency department visits, and
hospitalizations.

For chemotherapy treatment, for example, direct medical costs may

include the chemotherapy products themselves, other
medications given to reduce side effects of the
chemotherapy, intravenous supplies, laboratory tests, clinic
costs, and physician visits.
2- Direct Nonmedical Costs

Direct nonmedical costs are costs to patients and their families

that are directly associated with treatment but are not medical
in nature.

E.g.: Direct nonmedical costs include the cost of traveling to and

from the physician’s office, clinic, or the hospital; child care
services for the children of a patient; and food and lodging
required for the patients and their families during out-of-town
treatment.
 3- Indirect Costs

Indirect costs involve the costs that result from the

loss of productivity because of illness or death.

Indirect benefits, which are savings from avoiding

indirect costs, are the increased earnings or productivity
gains that occur because of the medical product or
intervention.

In the chemotherapy example, some indirect costs result

from the time the patient takes off from work to receive
treatment or reduced productivity because of the effects
of the disease or its treatment.
 4- Intangible Costs

Intangible costs include the costs of pain,

suffering, anxiety, or fatigue that occur because
of an illness or the treatment of an illness.

Intangible benefits, which are avoidance or

alleviation of intangible costs, are benefits that result
from a reduction in pain and suffering related to a
product or intervention.

It is difficult to measure or place a monetary value

on these types of costs.
 Alternative Method of
Categorization
The first category is health care sector costs, which include medical
resources consumed by health care entities.

These types of costs are similar to the definition of direct medical

costs but do not include direct medical costs paid for by the patient
(e.g., deductibles, co-payments) or other non–health care entities.

The second category is other sector costs. Some diseases and their
treatment impact other non–health care sectors, such as housing,
homemaker services, and educational services.

One example often noted is that when measuring resources used and
savings incurred by the treatment of patients with schizophrenia,
researchers should consider the impact on other sectors, including
 Alternative Method of
Categorization
The third category is patient and family costs. This categorization
includes costs to the patient and his or her family without regard to
whether the costs are medical or nonmedical in nature.

Thus, these costs include the patient’s or family’s share of direct

medical as well as direct nonmedical costs.

The fourth category is termed productivity costs and is analogous to

the economic term indirect costs but has the advantage of not being
confused with the accounting term with the same name.
 Perspective

To determine what costs are important to measure,

the perspective of the study must be determined.

Perspective is an economic term that describes

whose costs are relevant based on the purpose of
the study.

Conventional economic theory suggests that the

most appropriate and comprehensive perspective is
that of society.

Societal costs include costs to the insurance

company, costs to the patient, costs to the
 Perspective

Societal costs are not the most commonly seen in the PE literature
because it is difficult and time-consuming to estimate all of these cost
components.
In many cases, researchers are not interested in the overall costs of
each treatment alternative; instead, they are interested in the
differences in costs between two alternatives.

The most common perspectives used in PE studies are the

perspective of the institution or provider (e.g., hospital or clinic)
or the payer (e.g., Medicaid or private insurance plan) because these
may be more pragmatic to answer the question at hand.
 Perspective

The payer perspective may include the costs to the third-party

plan or the patient or a combination of the patient co-pay
and the third-party plan costs.
 If the perspective of the analysis is the hospital, the actual cost to
treat a patient should be estimated.

 If the perspective of the analysis is that of the payer, the amount

that is reimbursed should be used when estimating costs.

 If the perspective is that of the patient, his or her out-of-pocket

expenses, such as co-payments, deductibles, lost wages, and
 Timing Adjustments for
Costs
1- Bringing Past Costs to the Present:
standardization of Costs
When costs are estimated from information collected for more than 1
year before the study, adjustment of costs is needed; this is also
referred to as standardization of costs.

If retrospective data are used to assess resources used over a number

of years back, these costs should be adjusted, or valued at one point in
time.

 If you compare costs for patients who received treatment in 2005

with those for patients who received treatment in 2010, the
comparison of resources used would not be a fair comparison
because treatment costs tend to go up each year.

 Adjustment of the 2005 costs to the amount they would have cost in
 Timing Adjustments for
Costs
1- Bringing Past Costs to the Present:
standardization of Costs
 Timing Adjustments for
Costs
1- Bringing Past Costs to the Present:
standardization
Another of Costs
method used to standardize past costs is to multiply all of the
costs from the year the data were collected by the medical inflation
rate for that year.

Medical Consumer Price Index (MCPI) inflation rate has been

between 3% and 4% each year since 2005.
 Timing Adjustments for
Costs
2- Bringing future Costs (Benefits) to the Present:
Discounting
If costs are estimated based on dollars spent or saved in future years,
another type of modification, called discounting, is needed.

There is a time value associated with money : money received today is

worth more than the same amount of money received next year.

Using the discount rate, the present value (PV) of future expenditures and
savings can be calculated.

The discount rate generally accepted for health care interventions is

between 3% and 5%, but it is recommended that a comparison of results be
conducted using high and low estimates of various discount rates.

Varying these discount rates is an example of a sensitivity analysis.

 Timing Adjustments for
Costs
2- Bringing future Costs (Benefits) to the Present:
Discounting
The discount factor is equal to
1/(1 + r)t

 r is the discount rate.

 t is the number of years in the future that the cost or savings occur.

For example, if the expenses of cancer treatment for the next 3 years
are $5,000 for year 1, $3,000 for year 2, and $4,000 for year 3,
discounting should be used to determine total expenses in PV terms.

If one assumes that the expenses occur at the beginning of each year,
then first-year costs are not discounted
 Timing Adjustments for
Costs
2- Bringing future Costs (Benefits) to the Present:
Discounting
 Timing Adjustments for
Costs to the Present:
2- Bringing future Costs (Benefits)
Discounting
 Timing Adjustments for
Costs
2- Bringing future Costs (Benefits) to the Present:
Discounting
Example: Discounting costs and savings for an asthma clinic

This example shows why discounting (adjustment for the time value of
money) is needed when extrapolating estimated costs and savings into
the future. Start-up (first-year) costs of the clinic may be higher than
in year 2 and year 3. The savings (attributable to fewer
hospitalizations and emergency room visits) may not be seen until
after the first year of operation of the clinic. All costs and savings must
be valued at one point in time (year 1 or present value) to more
accurately compare costs with savings.
 Timing Adjustments for
Costs to the Present:
2- Bringing future Costs (Benefits)
Discounting
 Timing Adjustments for
Costs
3- Average versus marginal or incremental Costs

When deciding between medication A and medication B, a clinician

would find it useful to know the estimated difference in costs and
the estimated difference in outcomes between the medications to
determine whether added benefits outweigh the added costs.

Therefore, when comparing the costs of options, it is important to look

at the change in costs. The terms marginal costs and incremental
costs are often used to refer to this change or difference between
alternatives.

Marginal costs refer to the cost of producing one extra unit of

outcome or product.
• In pharmacoeconomics, we don’t just look at the total or
average cost of a treatment — we care about the extra
(incremental) cost compared to another alternative,
and whether that extra cost gives extra benefit.

• ✅ Why is this important?

• The ICER is often very different from the average cost of a treatment.
• You can’t judge a drug by its price alone — you must compare:
• How much extra it costs
• How much extra benefit it provides
 Timing Adjustments for
Costs
3- Average versus marginal or incremental Costs

The incremental cost-effectiveness ratio (ICER) is the change in

costs divided by the change in outcomes.

The ICER can be very different from the average costs, especially
when the difference in outcomes is small.
This tells decision-makers whether that
“extra outcome” is worth the “extra money.”
Let’s compare Drug A and
Drug B for hypertension: Effectiveness (QALYs
Cost per patient
gained)
Treatment
Drug A $1,000 1.0 QALY
Drug B $1,400 1.1 QALYs

Now calculate the ICER:

• Change in cost = $1,400 – $1,000 = $400
• Change in outcomes = 1.1 – 1.0 = 0.1 QALY
ICER=400/0.1​=$4,000 per QALY
✅ So even though Drug B is only $400 more expensive, the cost per extra QALY is
$4,000.
 Timing Adjustments for
Costs
3- Average versus marginal or incremental Costs

E.g.: A clinician is faced with the choice of

 treating 100 patients with treatment A (100 patients × $325 per
patient = $32,500)
 or 100 patients with treatment B (100 patients × $450 = $45,000),

It would cost $12,500 ($45,000 versus $32,500) more to treat 100

patients with treatment B.

Of the 100 patients treated with treatment A, 87 would have a

successful outcome, but 91 of the 100 patients treated with treatment
B would have a successful outcome (four extra
successes).
 Resources for Cost
Estimations
How does the researcher estimate common direct medical
costs?

 Sometimes these costs are measured directly during a clinical

study for each patient through record keeping and patient logs.

 Sometimes costs are collected retrospectively from medical

records or reimbursement claims data.

 Other times, these costs are estimated from various standard

lists of costs.

Sources of estimates for four types of common direct medical cost

categories are addressed: medications, medical services,
1. Direct Measurement During a Clinical Study

• Costs are recorded in real-time, patient by patient.

• ✔️Example:
In a clinical trial for a new diabetes drug:
• Researchers record:
• Drug dose and cost
• Lab tests
• Doctor visits
• Hospital stays
• Each item is logged per patient and multiplied by its cost.
• This gives very accurate, patient-specific cost data.
2. Retrospective Data (Looking Backward)

• Costs are collected after the treatment has occurred,

using:
• Medical records
• Insurance or reimbursement claims
• ✔️Example:
A study comparing cost of two antibiotics might use:
• Hospital billing data from 2018–2022
• Insurance claims showing drug cost, lab tests, hospital
days
• This is cheaper and faster than running a new trial.
3. Standard Cost Lists / Official Sources

• Sometimes, researchers do not have direct patient-level cost

data, so they use published sources.
• These may include:
• Government price lists
• Hospital billing tariffs
• Pharmacy price catalogs
• Medicare/Medicaid fee schedules
• National cost databases
• ✔️Example:
To estimate the cost of a colonoscopy, a researcher may use the
Medicare reimbursement rate or hospital’s published fees.
Types of Direct Medical Costs Typically Estimated

• The slide mentions four main cost categories:

[Link] → drug price per dose or treatment
course
[Link] services → diagnostics, dialysis, imaging,
procedures
[Link] costs → nurses, doctors, pharmacists,
technicians
[Link] → bed charges, ICU stays,
emergency visits
• Researchers pull cost data for these from any of the
three methods above.
 Resources for Cost
1- Medications Estimations
 The average wholesale price (AWP) is often used when calculating the
cost of pharmaceutical products in the United States.

The AWP is higher than what pharmacies, institutions, or third-party payers

actually pay for medications.

Although the AWP has long been used as a benchmark for prescription
prices, some argue that it has moved so far from the actual acquisition cost
that it is no longer useful.

 The average manufacturer’s price (AMP), calculated to reflect the

average amount paid to manufacturers by wholesalers after discounts are
included, is a more precise estimate of what buyers (pharmacies) pay for
medications.
 Resources for Cost
2- Medical services
Estimations

Medical services, such as office or clinic visits and outpatient

laboratory and surgical procedures, are frequently included in direct
medical cost estimates.

When the perspective is that of the purchaser (or payer),

various sources are available to estimate these costs to the payers.

A common source for US reimbursement rates (the amount

reimbursed by payers to the providers of health services) is the
Physician’s Fee Reference.
 Resources for Cost
Estimations
3- Personnel

When the perspective of the study is that of the provider of

health services (e.g., hospital, clinic, physician’s office, pharmacy)
and the provision of different health care alternatives involves a
difference in the amount of time spent by medical personnel,
attributing a cost to this difference is warranted.

To estimate these costs, the amount of time spent in the activity would
be multiplied by the salary plus fringe benefits of pharmacists.

Estimating the time for the personnel may include the use of estimates
based on similar services or may involve more precise work
measurement methods.
 Resources for Cost
Estimations
4- Hospitalizations

The level of the precision of estimates varies widely for studies that
include hospital costs as part of their evaluation.

In order from least precise (gross or macro-costing) to most precise

(micro-costing), four methods for estimating hospital costs are:

 Per diem
 Disease-specific per diem
 Diagnosis-related group
 Micro-costing
 Resources for Cost
Estimations
4- Hospitalizations

 Per diem

The least precise method of estimating hospital costs is the per diem
method of costing.

For each day that a patient is in a hospital setting, an average cost

per day for all types of hospitalizations is used as a multiplier.

E.g.: If the average cost reimbursement per day for hospitalizations of

all patients was $2,000 per day, the cost estimate for a 3-day stay
for appendicitis would be the same as the estimate for a 3-day stay
for cardiac bypass surgery.

That is: 3 days × $2,000/ day = $6,000

 Resources for Cost
Estimations
4- Hospitalizations

 Disease-specific per diem

It would be more precise to use estimated costs per day for

specific diseases, or a disease-specific per diem.

E.g.: The average reimbursement rate might be

 $1,500 per day for the appendicitis case ($4,500 for 3 days).

 and $10,000 per day for the cardiac bypass surgery case
($30,000 for 3 days).
 Resources for Cost
Estimations
4- Hospitalizations

 Diagnosis-Related Group

A relatively available and often-used method of estimating hospital

costs to the payer is the payment rate for DRGs.

This method is used to classify clinically cohesive diagnoses and

procedures that use similar resources.

Each patient is assigned one of more than 500 DRGs based on factors
such as principal diagnosis, specific procedures involved,
secondary diagnoses, and age.

The average reimbursement for each DRG can be used to approximate

the cost to the payer.
 Resources for Cost
Estimations
4- Hospitalizations

 Micro-costing

The most precise method of estimating hospital costs is micro-costing.

Micro-costing involves collecting information on resource use

for each component of an intervention to estimate and
compare alternative interventions.

E.g.: This is an example of micro-costing from the literature. Fentanyl and

remifentanil are opiates used for patients undergoing surgery. It has been
suggested that remifentanil speeds postoperative recovery because of its
short duration of action (which can lead to the patients being disconnected
from the breathing tube more quickly after surgery). One of the objectives of
this study was to compare costs to the hospital between patients who
Resources for Cost
Estimations
4- Hospitalizations

 Micro-costing