Pharmacoeconomics 3142 LecNote Ch3 - 4 For BPharm SoP UoG May 15 2016

3.
Decision Analysis and Pharmacoeconomic Evaluations
3.1. Basic Concepts of Probability
3.2. Definition and Theoretical Basis of Decision Analysis in Health
3.3. The Basic Steps of Decision Analysis
3.4. Evaluation of the Result of Decision Analysis
3.5. Possible Benefits and Common Criticisms of Decision Analysis

in Health
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 Probability is the study of randomness and uncertainty.

 In the early days, probability was associated with games of chance (gambling).
 The theory of probability provides the foundation for statistical inference.
 Some Common probability parlance in medical:
– A patient has a 50-50 chance of surviving a certain operation.
– Another physician may say that she is 95% certain that a patient has a particular
disease.
– A public health nurse may say that nine times out of ten a certain client will
break an appointment.
 We measure the probability of occurrence of some event by a number between
zero and one.
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• The more likely the event, the closer the prob. is to one and more unlikely it is the
closer the prob. to ‘0’.
– An event that can’t occur has a probability zero, and
– An event that is certain to occur has a probability of one.
• Health sciences researchers continually ask themselves
– if the result of their efforts could have occurred by chance alone or
– if some other force was operating to produce the observed effect.
• For example
– suppose six out of ten patients suffering from some disease are cured after receiving a
certain treatment.
– Is such a cure rate likely to have occurred if the patients had not received the treatment?
– Or is it evidence of a true curative effect on the part of the treatment?
• Question such as these can be answered through the application of the concepts
and laws of probability.
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Events & Sample Spaces

Sample Space
The sample space is the set of all possible outcomes.
Event
An event is any collection
of one or more simple events
Simple Events
The individual outcomes are called simple events.
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Example
Experiment: Toss a coin 3 times
• Sample space 
•  = {HHH, HHT, HTH, HTT, THH, THT, TTH, TTT}.
• Examples of events include

– A = {HHH, HHT,HTH, THH}
= {at least two heads}
– B = {HTT, THT,TTH}
= {exactly two tails.}
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There are two views of probability

1. Relative frequency probability
 If the process is repeated a large number of times, n , and if some resulting
event with the characteristic E occurs ‘m’ times,
 The relative frequency of occurrence of E, m/n, will be approximately equal to
the probability of E.
 Symbolically P(E) = m/n
2. Subjective Probability
 Probability measures the confidence that a particular individual has in the
truth of a particular proposition.
 This concept doesn’t rely on the repeatability of any process.
 In fact, by applying this concept of probability, one may evaluate the
probability of an event that can only happen once,
 For example, the probability that a cure for cancer will be discovered within
the next 10 years.
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Elementary Properties of Probability

(Axiomatic Approach to Probability)
The basic of this approach is embodied in three properties
1. Axiom of non-negativity
– Given some process (or experiment) with n mutually exclusive outcomes (called
events), E1, E2, ……En, the probability of any event Ei is assigned a nonnegative
number.
When two events A and B have no
– That is P(Ei)≥ 0 outcomes in common, they are said to
2. Axiom of exhaustiveness be mutually exclusive, or disjoint, events.
– The sum of the probabilities of the all mutually exclusive and exhaustive
outcomes is equal to 1.
P(E1)+ P (E2) +………P(En) = 1
– This is the property of exhaustiveness.
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3. Axiom of additive-ness
For Mutually Exclusive Events
• Consider any two mutually exclusive event, Ei and Ej.
• The probability of the occurrence of either Ei or Ej is equal to the sum of
their individual probabilities.
P(Ei or Ej) = P(Ei)+ P(Ej)
For Not Mutually Exclusive Events
• Suppose the two events were not mutually exclusive; in that case the
probability
P(Ei or Ej) = P(Ei)+ P(Ej) – P(Ei ∩ Ej)
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Calculating the probability of an event
Example:
 The subjects in the study consisted of a
Life times
sample of 75 men and 36 women. The Male Female
frequency of TB Total
Table shows the life time frequency of TB Case
(M) (F)
Case and the gender of these subjects.
 Suppose we pick a person at random from 1-19times (A) 32 7 39
this sample.
 What is the probability that this person will 20-99times (B) 18 20 38
be a male?
• We define the desired probability as the 100+Times (C) 25 9 34
number of subjects with the
characteristic of interest (male) divided
Total 75 36 111
by the total number of subjects.
Symbolically
– P(M)= number of males/ total number of
subjects = 75/111 = .6757
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Conditional Probability
• It is a measure of the probability of an event given that another event has occurred.
• When probabilities are calculated with a subset of the total group as the
denominator, the result is a conditional probability.
• If the event of interest is A and the event B is known or assumed to have occurred,
– the conditional probability of A given B, or the probability of A under the condition B, is
usually written as P(A|B),
• The conditional probability of A given B is equal to the probability of A∩B divided by
the probability of B, provided the probability of B is not zero.
• That is =>
P (A|B)= P (A ∩ B)/P (B), P (B) ≠ 0 and same way
P (B|A)= P (A ∩ B)/ P (A), P (A) ≠ 0
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Conditional Probability cont’d …
Example:
• Suppose we pick a subject at random from the 111 subjects and find that he
is a male (M).
• What is the probability that this male will be one who has TB Case 100
times or more during his lifetime?
Solution:
• This is a conditional probability and is written as P(C|M).
• The 75 males become the denominator of this conditional probability, and
25 the number of males who have TB Cases 100 times or more during their
lifetime, becomes the numerator.
• Our desired probability, then is P(C|M) = 25/75 = 0.33
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Conditional Probability cont’d …
Example:
• Using the equation and the date of Table-1 to find the conditional
probability, P(C|M).
Solution:
• According to the equation
• P(C|M) = P(C∩M)/ P(M)
• Earlier we found P(C∩M) = P(M∩C) = 25/111 = 0.2252.
• We have also determined that P(M) = 75/111 =0.6757.
• Using these results we are able to compute
• P(C|M) = 0.2252/ 0.6757 = 0.3333
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Bayes Theorem
• It describes the probability of an event, based on conditions that might be related to the event.
• It provides a way to convert a-priori probabilities to a-posteriori probabilities
• Bayes' theorem is stated mathematically as the following equation:
• Where A and B are events.

• P(A) and P(B) are the probabilities of A and B without regard to each other.
• P(A|B), a conditional probability, is the probability of observing event A given that B is true.
• P(B|A) is the probability of observing event B given that A is true.
For example,
• suppose one is interested in whether a person has cancer, and knows the person's age. If cancer
is related to age, then, using Bayes' Theorem, information about their age can be used to more
accurately assess the probability that they have cancer.
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Bayes Theorem
Example
• Given that 500 patients who have disease X were given Drug A
for two weeks. After two weeks of course of therapy patients
were assessed on the outcome the medication. The following
findings were obtained:
1. 80 % of the patients were cured
2. 5% of the patients have encountered mild adverse effects
• Solve the following question

1. What is the probability of side effects occurrence given that those patients were cured?
2. What is the probability of side effects occurrence given that those patients were not
cured?
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Monty Hall Problem
• The Monty Hall problem is a brain teaser, in the form of
a probability puzzle, loosely based on the American
television game show Let's Make a Deal and named
after its original host, Monty Hall.
• Suppose you're on a game show, and you're given the
choice of three doors: Behind one door is a car; behind
the others, goats.
• You pick a door, say No. 1, and the host, who knows
what's behind the doors, opens another door, say
No. 3, which has a goat.
• He then says to you, "Do you want to pick door No. 2?"
Is it to your advantage to switch your choice?
• Under the standard assumptions,
– contestants who switch have a 2/3 chance of winning the
car,
– while contestants who stick to their choice have only a
1/3 chance.
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Monty Hall Problem cont’d …
• The given probabilities depend on specific assumptions about how the host and
contestant choose their doors.
• A key insight is that, under these standard conditions,
– there is more information about doors 2 and 3 that was not available at the
beginning of the game, when the door 1 was chosen by the player: the host's deliberate
action adds value to the door he did not choose to eliminate, but not to the one chosen by
the contestant originally;
– another insight is that switching doors is a different action than choosing between
the two remaining doors at random, as the first action uses the previous information and
the latter does not.
– Other possible behaviors than the one described can reveal different additional
information, or none at all, and yield different probabilities.
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Joint Probability
• The intersection of two events A and B, A ∩ B, is the event consisting of all

outcomes that are in both events.
• The probability that a subject picked at a random from a group of
subjects possesses two characteristics at the same time.
Example:
• Ref. (Table ) what is the probability that a person picked at a random from
the 111 subjects will be a male (M) and be person who has TB Cases 100
times or more during his lifetime (C)?
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Joint Probability
Solution:
• The probability is written as P(M∩C)
• (M∩C) indicates the joint occurrence of conditions M and C.
• Number of subjects satisfying both of the desired conditions is found in
Table at the intersection of the column labeled M and the row labeled C
i.e. 25 since the selection will be made from the total set of subjects, the
denominator is 111.
P(M∩C) = 25/111 = 0.2252
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Multiplication Rule
• A probability may be computed from other probability.

• For example, a joint probability may be computed as the product
of an appropriate marginal probability and an appropriate
conditional probability.
• This relationship is known as the multiplication rule of probability.
• We may state the multiplication rule in general terms as follows for
any two events A & B:
P(A ∩ B) = P(B) P(A|B), if P(B) ≠ 0
or
P(A ∩ B) = P(A) P(B|A), if P(A) ≠ 0
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Addition Rule
• Given two events A and B, the probability that event A, or event B,

or both occur is equal to the probability that event A occurs, plus the
probability that event B occurs, minus the probability that the events
occur simultaneously.
• The addition rule may be written:

P(AUB) = P(A) + P(B) – P(A∩B)
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Addition Rule
Example:
• If we select a person at random from the 111 subjects represented in Table-1
what is the probability that this person will be a male (M) or will have TB
Cases100 times or more during his lifetime(C) or both?
Solution:
• The probability is P(MUC).By the addition rule as expressed this probability may
be written as P(MUC) = P(M) + P(C) - P(M∩C)
• We have already found that P(M)=75/111=0.6757, and P(M∩C) = 25/111 =
0.2252
• P(C) = 34/111= 0.3063
• Substituting these results in to the equation for P(MUC)= 0.6757+0.3063-0.2252
= 0.7568.
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Independence of Events
• If two events are independent, the probability of their joint occurrence is

equal to the product of the probabilities of their individual occurrences.
• Suppose that the probability of event A is the same regardless of whether or

not B occurs.
• In such cases we say that A and B are independent events.
• When two events with non zero probabilities are independent each of the
following statements is true:
1. P(A|B) = P(A), P(B) ≠ 0
2. P(B|A) = P(B), P(A) ≠ 0
3. P(A∩B) = P(A) P(B); P(A) ≠ 0, P(B) ≠ 0
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Complementary Events
• The complement of an event A, Ac, is the set of all outcomes in  that are not
in A.
• The probability of an event A is equal to 1 minus the probability of its
complement, which is written as A´, and
P(A´) = 1 - P(A)
• Earlier using the data in Table 1 we computed the probabilities:
• P(M) =75/111=.6757. P(F) = 36/111=.3243.
• The sum of these two probabilities = 1.
• This is because the events being male and being female are complementary
events.
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Complementary Events cont’d …
Example:
• Suppose that of 1200 admissions to a general hospital during a
certain period of time, 750 are private admissions.
• What is the probability of those are not private admissions?
Solution
• If we designate these as set A´, then A is equal to 1200 minus 750, or
450.
• we may compute P(A)=750/1200=0.625 and P(A´)= 450/1200
=0.375
• And see that P(A) + P(A´)=1
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Marginal Probability
• Given some variable that can be broken down in to ‘m’ categories

as A1, A2…..Ai,……Am and another jointly occurring variable into
‘n’ categories as B1, B2,…..Bj,….Bn
• the marginal probability of Ai , P(Ai), is equal to the sum of the
joint probabilities of Ai with all the categories of B.
P(Ai) = ∑ P (Ai∩Bj), for all values of j.
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Marginal Probability
Example:
• We use the equation and the data in Table-1 to compute the marginal
probability P(M).
Solution:
• The variable gender is broken down in to two categories male and female
and the variable ‘frequency of TB Cases’ in to 3 categories, 1-19 times (A),
20-99 times (B), 100+times (C).
• The category male occurs jointly with all 3 categories of the variable
‘frequency of TB Case’.
• The three joint probabilities are:
– P(M∩A) = 32/111 = 0.2883, P(M∩B) = 18/111 = 0.1662,
– P(M∩C) = 25/111 = 0.2252
• We obtain the marginal probability: P(M)= P(M∩A) +P(M∩B)+ P(M∩C) =
0.2883 + 0.1622 + 0.2252 = 0.6757
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3.2. Definition and Theoretical Basis of Decision Analysis in Health
• It is an explicit, quantitative, and systematic approach to decision making

under conditions of uncertainty
• People usually make decisions by relying on psychological shortcuts called
heuristics – leads to suboptimal outcomes
• Can focus on cost, outcomes or both
• Decision analysis is used when:
– There are real alternatives
– There is uncertainty
– There are consequences
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What is a Decision Tree?
 Decision tree is a visual

representation of Choices,
Consequences,
Probabilities, and
Opportunities.
 Can be used as visual aids to
structure and solve sequential
decision problems
 Especially beneficial when the
complexity of the problem
Decision Tree
grows
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What is a Decision Tree?
• SOLVING the tree involves Example Decision Tree

– pruning all but the best decisions
at decision nodes, and
– finding expected values of all
possible states of nature at
chance nodes
• CREATE the tree from left to
right
• SOLVE the tree from right to
left
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3.3. The Basic Steps of Decision Analysis
Step 1: STRUCTURE the tree
Step 2: Estimate PROBABILITIES
Step 3: Estimate OUTCOMES
Step 4: ANALYSE the tree (Average Out/Fold Back)
Step 5: Conduct SENSITIVITY ANALYSIS
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Step 1: STRUCTURE the Tree
• Entails diagramming the branches and nodes that represent the particular
problem being modeled.
• Identify the decision alternatives
• List the possible outcomes of each alternative
• Specify the sequence of events
• The choices one makes from the decision node must be mutually
exclusive
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Developing Decision Tree

 Decision tree is composed of nodes and branches
 Events are ordered from left to right.
 Temporal order is often followed for sake of clarity.
 There are three types of Decision Tree Nodes
1. Decision Node
– represents a point where a choice of alternatives can be made or
– indicating a choice facing the decision maker, typically at start of tree
– distinguished using Square () shape
2. Chance Node
– represents a point where potential events can occur (based on probabilities)
– represents an event which has multiple possible outcomes and is not under the decision maker’s
control. For an individual patient, which event they experience is uncertain.
– distinguished using Circle () shape
3. Terminal Node
– represents a point where the end results (payoffs) of a particular pathway are calculated
– distinguished using Triangle () shape
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Decision Tree Branches

• Decision Tree Branches- are representing alternative paths and events (either
chosen or based on probabilities) that may occur
• There are two types of Event branches in the decision tree:
1. Branches “sprouting” from a decision node
– Represent the set of actions being considered (strategies)
– They need not be mutually exclusive (e.g. A, B, A+B)
2. Branches from a chance node
– Represent the set of possible outcomes of the event
– Must be mutually exclusive and exhaustive
– Probabilities must sum to 1.0
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Example: Decision alternatives and possible outcomes
Alternatives for treating cancer using chemotherapy agents

1. Chemotherapy Choices:
 Drug A
 Drug B
2. Possible outcomes:
a. Clinical outcomes:
o Treatment Efficacy of Drug A and B
o Incidence of side effects of Drug A and B
b. Economic Outcomes:
o Total cost of treatment, including drug cost for chemotherapy Choices
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Possible Outcomes
Costs in Dollars
Success
Cost 1
Decision alternatives Side Effect
Failure
Cost 2
Drug A
Success
Cost 3
No Side Effect
Drug Choice Failure

for Disease X Cost 4
Success
Cost 5
Side Effect
Failure
Cost 6
Drug B
Success
Cost 7
No Side Effect
Failure
Cost 8
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Step 2: Estimate PROBABILITIES
• Usually derived from published studies

– Existing data: trial data or observational data
– Meta analysis: aggregating from multiple sources
• For each branch following a chance node, the conditional probability P is
needed:
• Probabilities are numbers between 0 and 1

• Probabilities for all branches out of a given chance node add to 1
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Example: Estimated Probabilities of Possible Outcomes
Probabilities of Outcomes
Chemotherapy
Incidence of Treatment Efficacy/Success
Choices
side effects With Side Effect Without Side effect
Drug A 0.30 0.65 0.75
Drug B 0.40 0.60 0.70
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Estimated Path
probability
Success
0.195
.65
Side Effect
.30
Failure
0.105
Drug A .35 Probabilities
must always
Success
0.525 sum to 1.00
No Side Effect .75 (100%)
.70
Drug Choice Failure
for Disease X .25
0.175
Success
.60 0.240
Side Effect
.40
Drug B Failure Probabilities
0.160
.40 must always
Success sum to 1.00
0.420 (100%)
.70
No Side Effect
.60
Failure
0.180
.30 107
Step 3: Estimate Outcomes
• Determine the values of outcomes for each of the choices.

• Outcomes include:
– Total cost
– Total utilities
– Life years (LY)
– Quality-adjusted life years (QALYs)
• Outcomes are entered at terminal nodes
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Example: Estimated Total Treatment Costs
Chemotherapy Total Treatment Costs

Treatment
Choices
Efficacy
With Side Effect Without Side effect
Success 3500 2500

Drug A
Failure 4500 3500
Success 3400 2400

Drug B
Failure 4300 3400
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Path Costs
Success 3500
.65
Side Effect
.30 Failure
4500
.35
Drug A
Success
2500
No Side Effect .75
.70
Failure
Drug Choice 3500
for Disease X .25
Success
3400
.60
Side Effect
.40
Failure
.40 4300
Drug B
Success
2400
No Side Effect .70
.60
Failure
3400
.30
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Estimated Costs for
each Paths
0.30 x 0.65 x 3500

Success
= 682.5
.65
Side Effect
.30 Failure
0.30 x 0.35 x 4500
= 472.5
Drug A .35
Success
.75
0.70 x 0.75 x 2500
= 1312.5
No Side Effect
.70
Failure
Multiply ‘Path
Drug Choice 0.70 x 0.25 x 3500 Probabilities’
for Disease X .25
= 612.5 by ‘Path
Success
Costs’
.60
0.40 x 0.60 x 3400
Side Effect = 816
.40
Drug B
Failure
0.40 x 0.40 x 4300
.40 = 688
Success
0.60 x 0.70 x 2400
No Side Effect .70
= 1008
.60
Failure
0.60 x 0.30 x 3400
.30
= 612 111
Step 4: ANALYZE the Tree (Average Out/Fold Back)
• Done by “rolling back” the tree to get “expected values”

• Decision tree is averaged out and “rolled-back” to get the expected value for
each strategy (work from terminal nodes towards decision nodes)
• Expected value is the sum of products of the estimates of the probability of
events and their outcomes
• Steps:
1. The value of outcome for each branch is multiplied by its respective
probability
2. At each chance node, Sum weighted outcomes for each potential path
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Estimated Costs
for each Paths
First Rollback step to determine Success
0.30 x 0.65 x 3500 = 682.5
Expected values of outcomes .65
Multiply ‘Path Probabilities’ by ‘Path Costs’ and

Side Effect
for Drug A and B chance nodes
sum to yield ‘Average Cost’ for each pathway

EV= 682.5 +472.5= 1155
.30 Failure
0.30 x 0.35 x 4500 = 472.5
Drug A .35
Success
0.70 x 0.75 x 2500 = 1312.5
No Side Effect .75
EV= 1312.5+612.5= 1925
.70
Failure
Drug Choice 0.70 x 0.25 x 3500 = 612.5
for Disease X .25
Success
0.40 x 0.60 x 3400 = 816
.60
Side Effect
EV= 816+688= 1504
.40
Failure
Drug B 0.40 x 0.40 x 4300 = 688
.40
Success
0.60 x 0.70 x 2400 = 1008
No Side Effect .70
EV= 1008+612= 1620
.60
Failure
0.60 x 0.30 x 3400 = 612
.30
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Final Rollback step to
determine Expected values of
outcomes for Drug A and B
Side Effect
EV = 682.5 +472.5
= 1155
Drug A
No Side Effect
EV = 1312.5+612.5
= 1925
Drug Choice
for Disease X
Side Effect EV = 816+688

= 1504
Drug B
No Side Effect EV = 1008+612

= 1620 114
Decision Step among choices Average Costs
• Drug A found lower in average
total cost than Drug B
Drug A
EV = 1155+1925
= 3080
Drug Choice
for Disease X
Drug B
EV = 1504+1620
= 3124
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Estimated Path
Given that Path Effectiveness in Life years
Effectiveness
(LYs) extended for Success
• Drug A – with SE- 8years, No SE- 10yrs 0.195 x 8= 1.6yrs
.65
• Drug B - with SE- 6.5years, No SE- 10yrs Side Effect
1.6yrs
.30
Failure
Drug A 0.105 x 0 = 0
.35
6.8yrs
Success
0.525 x 10= 5.2yrs
No Side Effect .75
5.2yrs
.70
Drug Choice Failure
for Disease X .25
0.175 x 0 = 0
Success
.60 0.240 x 6.5 = 1.6yrs
Side Effect
1.6yrs
.40
Drug B Failure
.40
0.160 x 0 = 0
5.8yrs
Success
Decision Step among choices 0.420 x 10 = 4.2yrs
.70
No Side Effect
• Drug A found Higher in average 4.2yrs
total Effectiveness lifeyears .60
Failure
extended than Drug B 0.180 x 0 = 0 116
.30
Cost Effectiveness and Incremental Cost
Effectiveness Ratio (ICER)
Estimated Estimated Avg. Cost Effectiveness

Avg. Cost Effectiveness ratio
Drug A 3080 6.8 453
Drug B 3124 5.8 539.3
Difference (Drug A to B) - 44 1 ICER= -44
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Step 5: Conduct Sensitivity Analysis
• Sensitivity analysis is the evaluation of the outcomes of the model

for various different levels of one or more input variables.
• Done to check whether changes in parameters influence model’s
results
• Perform one-way sensitivity analyses on all parameters to debug
tree
• In conduct a sensitivity analysis
o Choose those values or probabilities that are most uncertain or those
where a small difference has a big impact on the results
o Use reasonable ranges
o Calculate threshold values
o Set all cost/outcomes equal to zero; strategies should have same
expected value
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Step 5: Conduct Sensitivity Analysis
o By Choosing Drug A probability of No Side effects changes from 0 to 1 and calculating
corresponding estimated costs for each outcomes. Then finding threshold value or cutoff point.
Threshold value:
• Probability of NSE with
Drug A = 0.7 ; EV=$3080
Equation
• Drug A f(x) = -1100x - 3850
• Drug B f(x) = -1260x - 3960
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• Now you are familiar with the essential components of decision

analysis,
• Thus you are better able to evaluate decision analysis studies in
the published literature.
1. Determine whether the results are valid.
2. Should determine whether his or her patient population has
similar characteristics as those modeled in the study.
– Probability estimates should be similar to
• the values expected by the patients in question, and
• utilities should be similar to values that the patients put on health states.
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3. Must decide whether the strength of evidence used in

the study is acceptable.
This includes
 review of the quality of the studies used and
 whether sensitivity analysis was performed to determine the robustness
of the results that were reported.
4. Lastly, the patient’s values and aversion for risk must be
considered.
 Decision analysis assumes all patients approach risk similarly.
 If one strategy has overall greater utility, but requires an operation with
small risk of a severe complication that the patient is unwilling to accept,
it may not be the best choice for your patient.
 A different patient may be willing to accept that risk with hope for a better
outcome.
121
3.5. Possible Benefits and Common Criticisms of Decision Analysis in
Health
Benefits of Decision Analysis in Health

• It is a useful technique for assisting complex and uncertain decisions, where the best
option is not immediately obvious.
• By specifically including the results of research studies in the decision model, it can help a
practitioner make evidence-based decisions.
• Provides an explicit and systematic approach to decision making, which enables
clinicians to explain both to patients and colleagues how a particular decision has
been reached
• By incorporating patient values into the decision model, it also enables patients to be more
involved in the decision process and to directly influence the final decision
122
3.5. Possible Benefits and Common Criticisms of Decision Analysis in Health
Limitations of Decision Analysis in Health

• Sometimes the probability estimates necessary to populate a tree do
not exist in the research literature;
– a situation that necessitates using subjective estimates of probability
– Such estimates are subject to a number of forms of bias
• Utility measurement itself may also be questioned as an approach.
– Is it possible, or indeed appropriate, to try and quantify something which
is so subjective and emotional
• Decision analysis is often criticized
– for being too time consuming and
– artificially simplifying complex decision problems
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4. Costs and Time Preference
4.1. Key Concepts and Principles in Cost Analysis
4.2. Types of Intervention Cost Studies
4.3. Types of Costs
4.4. Conducting the Cost Analysis
4.5. Discounting of Costs
4.6. Adjusting for Inflation and Annuitizing Capital Expenditures
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4.1. Definitions, Key Concepts and Principles in Cost Analysis
Definition of Cost
• Cost is
1. An amount paid or required in payment for a purchase; a price; or
2. The expenditure of something, such as time or labor, necessary for the
attainment of a goal.
According to the American Heritage Dictionary
• Costs are more than transactions of money.
• Costs represent the consumption of a resource that could
otherwise be used for another purpose.
125
Cost analysis
• Cost analysis is the systematic collection, categorization, and
analysis of the costs of a program or disease.
• Analysis of the comparative costs of alternative interventions or
programs.
– Does not include consequences.
• Cost analysis provides a complete accounting of the expenses
related to a given policy or program decision.
• It supplies the most basic cost information that both decision
makers and practitioners require and forms the foundation of all
other economic analyses.
126
A cost study can serve multiple purposes

1. Cost estimates can underline the importance of a disease to
society
• when considered alongside its impact on morbidity and mortality and
• when compared with the economic burden of other diseases.
2. Cost studies may allow the identification of the drivers of
diagnosis and treatment costs.
3. Cost data can be fed into economic evaluations, so that
decision makers can ascertain the efficiency of various
approaches
• To diagnosing and treating a disease by examining their consequences
in relation to their costs.
127
Key Concepts and Principles in Cost Analysis
• The following concepts and principles are important to consider

when conducting cost analysis for program evaluation.
1. Costs are resources used, not money spent.
2. The perspective of the analysis affects the costs considered.
3. Costs must be adjusted to account for the passage of time.
4. Costs can be variable or fixed.
5. Cost analyses should distinguish between marginal and
average costs.
128
Costs are resources used, not money spent
• Cost analysis considers the value of all resources used in providing a service
whether or not the resources were purchased directly by the program.
• Providing a service or operating a program typically requires two general types
of resources:
– Personnel and non-personnel costs
• In many social service programs, staff time is the primary resource necessary
for delivering a service.
• In addition, a program is likely to require non-personnel resources
– such as office space and facilities,
– supplies an materials, training,
– equipment, contracted services, travel, and utilities.
129
Costs are resources used, not ….
• Program participants also contribute resources in the form of

– time spent in program activities and
– in some cases, out-of-pocket costs for transportation.
• A program’s may use of resources at no cost
– For example, volunteer labor, donated office space, and participants’ time—
• However, it creates an opportunity cost for society, since those
resources could be used productively in other ways.
– The time that a participant spends attending program activities might
otherwise be spent in paid employment, for example,
– while office space donated to a program might be filled by another provider.
– Moreover, services or items offered as in-kind contributions to one agency
may need to be purchased by another.
130
The perspective of the analysis affects the costs considered
• Defining the perspective of a cost analysis answers the question,

“Costs to whom?”
– It operates as a filter for selecting the set of cost elements that should be
included in the analysis.
• The questions that a cost analysis seeks to answer affect the choice
of cost perspective.
• Cost analyses commonly consider the perspective of:
1. The funding agency or government;
2. The service provider or implementing agency;
3. The client or recipient of services; or
4. Society as a whole.
131
The perspective of the analysis affects ….
• The perspective of society reflects a combination of unduplicated

costs to
– the government (Federal, State, or local) or funding agency,
– the service provider, and
– the recipient of services.
• Analyzing costs from the perspective of society is important
– when a cost estimate is used in a cost-benefit analysis that
considers benefits accruing to both individuals and government.
132
Defining the Purpose and Scope of the Cost Analysis
• Before beginning the cost analysis, the evaluator should

engage internal and external stakeholders
– e.g., agency leadership and staff, legislators, funders
• Involvement of stakeholders are important to:
1. Clarify the goal and audience for the analysis
2. Clearly define the service to be analyzed
3. Specify the time period to be covered
133
What are the goals and who is the audience for the cost analysis?
• Evaluators should consider the questions that need to be

answered through a cost analysis,
– who needs the information, and
– how the information will be used.
• For instance, a cost analysis can be designed to compare the
costs of two programs,
– to explore the cost of expanding an existing program, or
– to provide information needed to compare a program’s costs and benefits.
• At the most basic level, a cost analysis can help to understand the
costs of providing a program or service.
134
What program or service will be analyzed?
• Before beginning a cost analysis, it is important to define

– the intervention, service, or program to be analyzed.
• One way is to define the individual activities or components that
compose the program or service, and its beginning, middle, and
end.
• When identifying program activities or components,
– it may be helpful to begin by labeling broad categories and
– identifying individual activities within each category.
135
What program or service will be analyzed?
• For Example costs can be analyzed by dividing into two broad

categories:
1. Direct service-related costs
• specific activities included, for example, working directly with
clients, making referrals, and conducting case management.
2. Administrative costs
• For example provision and receipt of supervision, training, and
outreach, among others.
136
What time period will be covered?
• Clearly defining the time period over which cost data will be collected is also
important.
• Cost analyses may cover
1. Several years
• to provide information on how costs vary over time or
2. Focus on a single year
• that is considered to be representative of the program’s typical
operating state.
• Evaluators should also specify the program’s stage of implementation during
the cost analysis because costs are likely to differ between
– a startup or planning period and a period of steady-state implementation,
– when the program is operating at or near full capacity.
137
4.2. Types of Intervention Cost Studies
Cost-of-illness
analysis
Cost- Cost-benefit
consequence Analysis (CBA)
Analysis
Cost- Cost-
minimization effectiveness
Analysis Analysis (CEA)
Cost-utility
Analysis (CVA)
138
4.3. Types of Costs
Definitions of some of the most common terms used to

categorize costs.
• These definitions apply to both the costs associated with a health
intervention and the costs of health outcomes.
1. Financial and Economic costs
2. Medical costs, Nonmedical costs, Productivity losses, and
intangible costs
3. Operating and Capital costs
4. Fixed and Variable costs
5. Total, Average and Marginal Costs
139
Financial and Economic costs
Financial (Explicit) costs

• are the real-money outlays for resources required to produce a program or
intervention and to manage a patient's health outcome
– e.g. salaries, rent, medical supplies
Economic (Implicit) costs
• Are the opportunity costs of the resources used to implement the intervention
– i.e., the value of the resources if they had been used for another productive purpose.
• Economic costs include not only direct money outlays but also the value of resources
for which no money was spent
– E.g. Volunteer time, space in the local public health department, donated brochures
• Economic costs provide a more complete estimate of intervention or health-outcome
costs than financial costs
– Because they include all of the resources used to implement a prevention strategy
or manage a health outcome
140
Financial and Economic costs
Example of Financial and Economic costs

• Suppose you choose to leave a job that is paying you $50,000 per year to
open a bar. After a year of operation, you determine the bar generates
approximately $200,000 while costs are approximately $70,000. The costs
include purchasing food, alcohol, and employee wages.
• Calculate your explicit and implicit costs after a year of a bar business
operation.
Solutions
• The $70,000 is your explicit costs because those costs require direct
payments for purchase.
• The $50,000 per year that you gave up to start the bar are the opportunity
(implicit) costs.
141
Opportunity costs
Opportunity costs
• These are costs of economic benefits forgone when one therapy is
used instead of the next best alternative therapy.
• It includes the cost of lost opportunity or revenue forgone.
For example
• The time one takes to see a cinema is a cost for the viewer
• Because it is time that cannot be used again.
– i.e. The opportunity to use it for another purpose has been foregone.
• Same is the case with the time taken for consulting with a
particular doctor.
142
Opportunity cost cont’d
• Opportunity cost recognizes that there are limited resources available

for utilizing every treatment
– therefore the rationing of health care is implicit in such a system.
• Good investments are made when the benefits of the investment are
greater than or equal to the value of opportunities you have forgone.
Implications of opportunity cost
• Deciding to do A implies deciding not to do B
– i.e. value of benefits form A>B
• Cost can be incurred without financial expenditure.
• Value not necessarily determined by “the market”.
143
Example of opportunity cost
Possible Health Expenditure in a Year
Pediatric Care Care of Elderly Opportunity Cost of Treating

(No. of Children Treated (No. of Elderly Treated Children in Terms of Elderly Patients
in’000’s) in’000’s) Forgone in ’000’s
0 30 0
1 28 2
2 24 6
3 18 12
4 10 20
5 0 30
Medical costs, Nonmedical costs, Productivity losses,
and intangible costs
Direct medical costs

• Direct medical costs are associated with monetary transactions and
represents costs that are incurred during the provision of care.
• It is incurred for medical products and services used for the prevention,
detection and treatment of a disease
• This includes
– cost of drugs, supplies, laboratory tests,
– payments for doctor's fee,
– fee or salaries for other health care professional's time and labor
– fee for hospitalization
145
Direct non-medical costs
• Costs for non-medical services because of illness but do not involve

purchasing medical services.
• It includes
– cost of transportation to hospital or doctor's office,
– costs of special clothing or other items needed because of illness
– hotel room expenses near the treatment place
– food, family care, expenses for aids and related items.
– costs such as those associated with a mass media campaign,
• including media development, training, materials, and the cost of
advertising.
146
Indirect nonmedical costs
• Indirect costs include lost • These are costs of reduced

productivity from a disease productivity
which can manifest itself as • Includes
– a cost to the economy or taxation – Absenteeeism- decreased ability to
system as well as work
– “Presenteeism” - on the job, being
– economic costs to the patient and his
paid, not inefficient
family.
– leisure time lost
• Economic value can be assigned – wages and salaries lost due to
to each unit of time lost from morbidity
normal activities. – income forgone due to premature
death or resignation of job due to
inability to work.
– Caretaker time
147
Intangible costs
• Costs incurred other non-financial outcomes of disease and

medical care which are not clearly expressed in money value.
• These costs can be described as the “psychic” cost of diseases.
• Intangible costs includes
– costs of mental agony, pain, suffering, grief associated to the an
intervention.
• Intangible costs are difficult to quantify and are seldom included in
an economic evaluation.
148
Operating and Capital costs
 Costs for resources use to deliver health care can be categorized as:
1. Operating costs
o Are the ongoing costs of a program required to deliver goods or serves
o They are generally considered to be the costs that accrue over the budget
period, usually calculated on an annual basis
2. Capital costs
o Are those costs used for the purchase of assets that have a useful life
of longer than 1 year.
o Occur at a single point in time for an item that may be used throughout
the life of a program.
o Examples of capital costs include vehicles, computers, and
microscopes.
149
Fixed and Variable costs
• Costs can be further categorized by the relationship between their expenditure and the
production of an output
• In general, operating costs fall into two categories
1. Fixed costs
o Are those whose total remains constant (within a relevant range), even though
the volume of the activity may vary.
o Examples include rent and the design and production of advertising media.
o In the short run, fixed costs do not change in response to the number of clients
being served or the amount of product delivered.
o Capital costs are considered fixed costs
2. Variable costs
o Are those that respond proportionately to change in the volume of activity.
o They vary with the number of clients served.
o Examples include test kits for HIV, condoms, bicycle helmets
150
Total, Average and Marginal Costs
• Once costs are collected and categorized, one may want to analyze them in relationship to
the outputs they are used to produce.
• In such cases, it important to distingue between the concepts of total, average, and
marginal costs.
Total Cost
• The total cost of an intervention or for treating a health condition
• It is the sum of the accumulated costs of producing a given level of output
• Output can be defined as either the result associated with the program or intervention under
study or the health care and other resources provided to treat a health condition
• Total costs(TC) : The sum of total fixed costs and total variable costs.
TC = TFC + TVC
• Total cost (TC) is expressed as follows: Where:
Q1 = Quantity of resource 1 ;
TC = (Q1 x P1) + (Q2 x P2) + … + (Qn x Pn) P1 = Value of resource 1
151
Average Costs (AC)

• Average cost are total costs divided by output. AC = TFC/q + TVC/q
• Types of average costs
1. Average Fixed Cost- AFC = TFC/Q.
• The average fixed cost function continuously declines as production increases.
2. Average Total Cost (ATC) - ATC = Total Cost/Q
3. Average variable cost (AVC)- AVC =TVC/Q.
• The average variable cost curve is typically U-shaped.
• It lies below the average cost curve and generally has the same shape - the
vertical distance between the average cost curve and average variable cost curve
equals average fixed costs.
• The curve normally starts to the right of the y axis because with zero production
152
Marginal cost
• It is the change in total costs that arises when the quantity produced
changes by one unit.
• It is the cost of producing one more unit of a good.
• Mathematically, the marginal cost (MC) function is expressed as the first
derivative of the total costs (TC) function with respect to quantity (Q).
• The marginal cost may change with volume, and so at each level of
production, the marginal cost is the cost of the next unit produced.
MC = TC/Output
MC = TVC/Output
153
Figure: Typical Average & Marginal Cost Curves

154
4.4. Conducting the Cost Analysis
Collection of Data on Medical Costs

• There are two sources of information in collecting medical cost data/or
medical resources used
1. Primary data collection methods 2. Secondary data collection methods
• Clinical trials • Administrative/claims databases

• Naturalistic trial/observation cost/ • National Hospital Discharge Survey
accounting system studies
• Patient bills • Literature
• Provider-specific claims data • Expert opinion
• Activity Based Costing
155
• All of the intervention cost studies rely on the calculation of both
the costs and the healthcare benefits or health effects of the
healthcare intervention under investigation.
• There are six stages to derive the cost components of the
intervention cost study:
1. Study Perspective
2. Timeframe
3. Cost Identification
4. Cost Measurement
5. Valuation of cost data
6. Sensitivity Analysis
156
1. Study Perspective
• A pivotal feature to take into account when conducting a cost analysis is the
perspective from which the costs are measured,
– be it a national, regional, or municipal government perspective;
– that of an employer; an insurance company; a health maintenance
organization;
– or the individual's perspective such as that of a physician or a patient.
• The perspective adopted in most forms of health economic analyses is the
societal or governmental perspective
– since this allows healthcare resources to be allocated to maximize social
welfare.
157
2. Timeframe
• It is important to indicate the time over which the costs of any healthcare
intervention are distributed.
– The timeframe can affect the costs of any intervention.
• Determine the analytic horizon (i.e., the time over which the costs and
effects of a given health-care intervention are derived).
– Costs may begin before the healthcare intervention
• such as those incurred in the construction of new clinics and medical
facilities to see patients,
– while other costs may be ongoing
• in the form of salaries for medical staff and equipment.
158
2. Timeframe
• Analytic horizon of a given economic analysis should last long enough to

capture that portion of time during which
– individuals are affected by the healthcare intervention and
– any benefits that such interventions continue to yield in the form of
positive health outcomes for those individuals enrolled in the healthcare
intervention.
159
The identification of costs may be divided into three categories:

1. Health system costs
 Health system costs are those associated with the “organization and
operating costs within the healthcare sector.”
2. Patient-based costs
 derived from “costs borne by patients and their families, (and include)
out-of-pocket expenses, patient and family input into treatment, time lost
from work, and “psychic costs” attributable to pain and suffering.”
 Nonmedical costs such as transportation and support for ancillary
workers, homecare workers, and other out-of-pocket expenses may be
included to gain an overall picture of the costs
3. External and intangible costs.
160
161
162
4. Cost Measurement
• Measuring healthcare costs is a demanding process

• Ensure that the cost inputs selected for analysis are measured in appropriate
physical and natural units.
• Adding up all the cost components may yield overlapping areas of similar
resource use e.g. among very busy and not busy clinics
• In such cases it becomes difficult to separate the actual amount of overhead
expenses which is being consumed separately.
• Thus, it needs to make a reasonable estimate of the various amounts
involved which include:
– The electricity, heat, rent of hospital space used
– The number of employees available,
– The size or area of clinic space used,
– The number and volume of patients seen.
163
5. Valuation of cost data
• Healthcare valuation of costs is achieved using

– local currency and local prices for goods and services
• Normally approximated by healthcare charges and parameters set by
– healthcare authorities or private insurers through negotiations
• Current and future healthcare costs are valued in constant monetary
terms
– to remove the potentially confounding effects of inflation and interest rate (by
discounting).
• The four main approaches to the valuation of costs include
1. Using market prices, be they actual or proxies from some reference point
2. Computing the time lost by patients as some measure of indirect costs
3. Using disability and rehabilitation payments to estimate lost productivity;
4. Reviewing policymaker's overall perceptions of costs, whenever possible.
164
6. Sensitivity Analysis
• Given the potential for actual or accidental uncertainties contained

in the information used to conduct cost analyses,
– the data used to derive the information often are subjected to the rigors
of a sensitivity analysis,
• in which a range of plausible numeric values are run through the
analyses to simulate real-world imprecision,
• both in the quality of the data and in that of the economic model itself.
• Sensitivity analyses are particularly useful in determining the
robustness of the overall cost analyses.
165
4.5. Discounting of Costs
• Many decisions made today will have repercussions next year and in
the years thereafter.
• We need a method for comparing the desirability of outcomes that
include consequences occurring at different times in the future.
• The theoretical justification for discounting is based on two facts:
1. Time preference
• most people would accept less money to receive it sooner
2. Opportunity cost
• less money can be invested by society and
• allowed to grow at a compound rate of interest to yield the
money required for future costs.
166
Discounting Process
• In discounting process consider the time value of money

• Adjusts future costs to present costs
• Value of a dollar today is worth more than a dollar in the future NOT because
of inflation
• If values are not discounted,
– the benefit or cost in first year will remain stable and
– may lead to false conclusion about value of the benefit
• No consensus on how to discount or how much to discount
– A discount rate (r) of 3-8% per year has been suggested
167
Discounting
Future
Now
Past
168
Discounting Formula
• Given a stream of costs C1, C2, …, CT, the Present Value (PV) is calculated
as:
Whereby
• 1/(1+r) t is called the discount factor;
• r is rate of discounting
• The present value of cost c in t years at interest (a.k.a. “discount”) rate i is:
169
Issues in Discounting
• While there is universal acceptance of the need to discount,
• There is much controversy over

 The appropriate discount rate to use,
 Whether to discount health benefits as well as costs, and
 Whether to use the same rate to discount costs and benefits.
170
Examples for Discounting
Example 1
• How much would you pay today for a promise of receiving $100 in
five years?
Solution
PV = 100 / (1+i)5
• If we use an interest rate of 7%, we get:
PV = 100 / (1.07)5 = $71
• Note that without discounting (i=0), the PV would be $100.
171
Example for Discounting
Example 2
• How many dollar you get today (i.e. 2016GC) if your grand- grand-
grand- father (500yrs back) had opened a bank account and saved
one dollar to you?
• Assume an interest rate of 6% and no inflation.????????????
Solution
• Given: PV=1dollar, interest rate=6%, t=500yrs
• Unknown: FV=?
• Formula: PV = FV/(1+i)t
• FV = PV x (1+i)t = 1 x (1+0.6) 500
172
Example for Discounting
Example 3
• Suppose that a program will cost $1,000,000 immediately, $1,000,000 one year
from now, $500,000 two years from now, and $500,000 three years from now.
• What will be the present value of the costs of the program?
Solution
• The present value of the costs of the program is calculated using discounting
formula as shown below
PV = 1,000,000/(1+i)0 + 1,000,000 /(1+i)1 + 500,000/(1+i)2 + 500,000/(1+i)3
• If we use a discount rate of 5%,
we get: PV =1,000,000 +952,381 + 453,515 + 431,919 = $2,837,814
• Note that without discounting (i=0), the PV would be $3,000,000.
173
Discount Factors
Discount Factor Cumulative

Year (1+r)n
1 / (1+r)n Discount Factor
1 (1+0.05)1 = 1.050 0.952 0.952
2 (1+0.05)2 = 1.103 0.907 1.859
3 (1+0.05)3 = 1.158 0.864 2.723
4 (1+0.05)4 = 1.216 0.823 3.546
5 (1+0.05)5 = 1.276 0.784 4.330
Using a 5% discount rate
174
Inflation
• Inflation is a sustained increase in the average level of prices.
• The rate of inflation is the percentage change in average prices
from one year to the next
• Data sources used in adjusting for Inflation
1. For prices that tend to increase at the rate of general prices (e.g.,
consumer goods)
• use the Consumer Price Index (CPI)
2. For items whose prices rise faster than the general rate of inflation
• use a component of the CPI, such as the Medical Care component of CPI
3. For wage
• Use either an index of hourly wages or earnings
175
Inflation Example
• Suppose you want to use information from a published

manuscript that listed the cost of a severe adverse event of febrile
neutropenia in 1983 dollars to be $1,531.
• How would you adjust that figure to current dollars?
• Index:
– 1983 (base year)=100
– 1998 = 242.7
• C(1998) = $1,531 * 242.7 / 100 = $3,716
176
Annuitization of capital costs
• Capital costs represent an investment at start-up in an asset

which is used and depreciated over time.
– Such as Vehicles, equipment, buildings
• Therefore, annuitize the initial capital outlay over the useful life of
asset and calculate the equivalent annual cost (E)
177
METHODS: How to annuitize capital costs to derive the equivalent annual cost
• The approach can be generalized to include the situation where the equipment, of
buildings have a resale value at the end of the intervention, such that:
178
• For new equipment this method can be applied unambiguously

• While for old equipment the recommended approach is to use the
replacement cost of the equipment
• In determining the useful life and resale value of an asset (n and S) it is
important to make a distinction between
– the physical life of equipment and
– its useful clinical life (which is depends on technological change).
• In choosing a discount rate analysts typically chosen one of the
following two conventions:
1. The government announces a common discount rate for all public sector
projects.
2. Alternatively, to use a rate consistent with the existing literature
• A 3% discount rate has been the de facto convention for health economic evaluation
179
EXAMPLE: Annutizing the cost of vehicle in a cost-effectiveness study
Question:
• A cost-effectiveness study which involve the purchase of four vehicles, each
costing US $20,000 (in 2016 prices). The cost of vehicles (a total of US$
80,000) was needed to annuitized over an expected life of 10 years and at a
discount rate of 3%. Assumed the resale value to be zero.
• Calculate the equivalent annual economic cost of the vehicles
Solution:
180

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3.

Decision Analysis and Pharmacoeconomic Evaluations

3.1. Basic Concepts of Probability

3.2. Definition and Theoretical Basis of Decision Analysis in Health

3.3. The Basic Steps of Decision Analysis

3.4. Evaluation of the Result of Decision Analysis

3.5. Possible Benefits and Common Criticisms of Decision Analysis

 Probability is the study of randomness and uncertainty.

Events & Sample Spaces

Experiment: Toss a coin 3 times

•  = {HHH, HHT, HTH, HTT, THH, THT, TTH, TTT}.

• Examples of events include

= {at least two heads}

= {exactly two tails.}

There are two views of probability

Elementary Properties of Probability

P (B|A)= P (A ∩ B)/ P (A), P (A) ≠ 0

• Where A and B are events.

• Solve the following question

• The intersection of two events A and B, A ∩ B, is the event consisting of all

• A probability may be computed from other probability.

• Given two events A and B, the probability that event A, or event B,

• The addition rule may be written:

• If two events are independent, the probability of their joint occurrence is

• Suppose that the probability of event A is the same regardless of whether or

• Given some variable that can be broken down in to ‘m’ categories

P(Ai) = ∑ P (Ai∩Bj), for all values of j.

• It is an explicit, quantitative, and systematic approach to decision making

 Decision tree is a visual

• SOLVING the tree involves Example Decision Tree

Step 1: STRUCTURE the tree

Step 2: Estimate PROBABILITIES

Step 3: Estimate OUTCOMES

Step 4: ANALYSE the tree (Average Out/Fold Back)

Step 5: Conduct SENSITIVITY ANALYSIS

• Identify the decision alternatives

• List the possible outcomes of each alternative

• Specify the sequence of events

Developing Decision Tree

Decision Tree Branches

Alternatives for treating cancer using chemotherapy agents

Drug Choice Failure

• Usually derived from published studies

• Probabilities are numbers between 0 and 1

Drug A 0.30 0.65 0.75

Drug B 0.40 0.60 0.70

• Determine the values of outcomes for each of the choices.

Chemotherapy Total Treatment Costs

Success 3500 2500

Success 3400 2400

0.30 x 0.65 x 3500

• Done by “rolling back” the tree to get “expected values”

Multiply ‘Path Probabilities’ by ‘Path Costs’ and

sum to yield ‘Average Cost’ for each pathway

Side Effect EV = 816+688

No Side Effect EV = 1008+612

Estimated Estimated Avg. Cost Effectiveness

Drug A 3080 6.8 453

Drug B 3124 5.8 539.3

Difference (Drug A to B) - 44 1 ICER= -44

• Sensitivity analysis is the evaluation of the outcomes of the model

• Now you are familiar with the essential components of decision

3. Must decide whether the strength of evidence used in