Principles of Economic Analysis 

Associate Professor of Anesthesiology, and Associate Vice President for Health Sciences. Received from the University of Utah, Salt Lake City, Utah. Submitted for publication August 27, 1996. Accepted for publication January 2, 1997. Address reprint requests to Dr. Sperry: the University of Utah, 50 North Medical Drive, Salt Lake City, Utah 84132. Address electronic mail to: rsperry@anesth. med. utah. edu. A basic economic problem is producing and distributing goods and services for unlimited human desires and needs when resources are limited. The fundamental principles of economics apply to health care just as to other sectors of the economy. 1, 2 David Eddy illustrates this point: “If health interventions were offered for free, if people had infinite incomes, if programs such as Medicaid had unlimited budgets, the design of a practice policy could stop with the comparison of benefits and harms; every intervention for which the benefits outweighed the harms should be recommended and performed. However, health interventions are not free, people are not infinitely rich, and the budgets of programs are limited. For every dollars worth of healthcare consumed, a dollar will be paid. ”3In medical practice, each patient's welfare is paramount. According to Eisenberg, “It is essential that the first commitment of the ethical physician be to the patient. However, to suggest that medical decision making can be divorced from consideration of cost denigrates the complexity of patient care. ”4 A physician who refuses to examine the economic consequences of his or her medical practice does not protect the welfare of his or her patients, at least not in the long run. The cost of a medical intervention must be balanced against the health outcome produced and the amount of money we are able and willing to spend. The fundamental premise of this article is that high-quality medical care demands that physicians be aware of the economic consequences of the practice of medicine. Yet most physicians are not prepared to assess these economic consequences. An increasing number of research manuscripts are published that purport to examine issues in medical economics, yet many physicians do not have the training to understand and to criticize the growing literature on health-care economics. Here I try to address this issue. I address two fundamental concepts of health-care economics: costs and benefits. In addition, I discuss three common types of economic analyses: cost-identification analysis, cost-effectiveness analysis, and cost-benefit analysis. An understanding of these two concepts combined with a working knowledge of the three types of economic analyses will help an interested physician to understand and criticize studies of health-care economics. The most important feature about costs is that they are difficult to measure accurately. It is essential, therefore, that every economic study explicitly identifies which costs are counted and which are excluded from the study. It is also essential that the type of costs reported be stated explicitly. There is confusion in published economic analyses about the concept of costs. 5The first major issue with costs is that there are different types: fixed, variable, total, marginal, and average costs. When a medical service is rendered, resources are consumed that have both a fixed and a variable component to their cost. Fixed costs do not change with alterations in the level of production in short periods of time. For instance, the mortgage on the hospital building and payments for anesthesia equipment would not change if the number of patients admitted to the hospital decreased by 10%. Variable costs change in proportion to changes in the level of production. The cost for medical supplies, for instance, may be expected to increase by approximately 10% when the number of patients in the hospital increases by 10%. The total cost is the sum of fixed and variable costs. For example, if an anesthesia machine is purchased on a 5-yr contract, then the yearly fixed cost for administering general anesthesia with the machine would equal the payments necessary to meet the contract. The yearly variable cost for delivering general anesthesia may include the cost for scheduled machine maintenance and supplies, plus the cost of volatile anesthetics and diluent gasses. The variable costs depend on the number of hours the machine is used. Suppose that the yearly payment for the anesthesia machine is 10, 000, and that the variable costs are 100 per patient-hour. Then the total cost of delivering general anesthesia can be represented by the cost function: Equation 1. Although total cost is usually the important measure, fixed and variable costs may be appropriate measures in certain circumstances. As with other issues surrounding the concept of costs, it is most important that authors of an economic analysis be explicit about the costs measured and reported. Another way to look at costs is to examine marginal or average costs as compared with total costs. The marginal cost of a medical service is the cost of treating one more or one fewer patient. The average cost of a medical service is the total cost divided by the total number of patients treated. Both of these costs are reported in the same units (such as dollars per patient), and this can lead to confusion. Marginal and average costs generally are not equal. 6 The context determines which type of cost (total, average, or marginal) is the appropriate cost for a given analysis. Using our previous example of the cost of providing general anesthesia with an anesthesia machine that has a cost function total cost of 10, 000 +100 x patient-hours, the marginal cost function is the slope of the total cost curve (the first derivative with respect to patient hours), which in this case is 100 per patient-hour. The average cost function is calculated by dividing the total cost by patient-hours, or in this case, 100 +10, 000/patient-hours. The curves representing total cost, average cost, and marginal cost for this medical service are presented in Figure 1. The second important issue relating to the concept of costs is discounting, which is fundamental to all financial analyses. The idea is that a promise to receive a dollar next year is worth less than receiving a dollar today. Three fundamental reasons make this true: inflation, the investment opportunity for money, and risk. The value of a dollar next year will be less than the value of one today because of general economic inflation. A value of a dollar next year will be less than the value of one today because today's dollar could be invested and interest would be paid on today's dollar. A promise to receive a dollar next year is worth less than an actual dollar today because something could happen in the meantime to leave the promise unfulfilled. To induce a rational economic entity to forgo a dollar today in exchange for a promise of a payment next year, the promise should be for more than one dollar. The “discount rate” determines the difference between one dollar and the promised amount. If a discount rate of 5% is required, then the promise must be for one dollar plus 5%, or 1. 05. The discount rate must account for inflation, forgone investment opportunity, and risk. Risk is an important issue for financial investments but does not often come into play in medical economic analyses. The important issues for us to consider are inflation and forgone opportunity. Both of these issues can be combined into one discount rate. The typical discount rate in this situation is 3% greater than the rate of inflation. 7The common way to discuss this issue is in terms of “present value. ” A present value calculation is the inverse of the example just given. The present value of 1. 05 next year is 1. 00 at a discount rate of 5%; that is, a promise to pay me 1. 05 next year is the same to me (presuming that I am economically rational) as a payment of 1. 00 today. Just as money that is left in a bank can earn compound interest, so the idea of compounding comes into play in discounting. If I were to leave 1. 00 in the bank for 2 yr at an interest rate of 5%, I would have 1. 00 plus 5%, or 1. 05, at the end of 1 yr, and 1. 05 plus 5%, or 1. 1025, at the end of 2 yr. The same can be said for discounting. The promise to pay me 1. 1025 in 2 yr is equivalent to paying me 1. 00 today, or the present value of 1. 1025 in 2 yr is 1. 00 at a discount rate of 5%. Similar to monetary benefits received in the future, costs that I pay in the future also should be discounted to a present value. In this case, inflation works in my favor because the dollars I pay back next year will be worth less than the dollars I have today. Costs in a medical economic study also should be discounted. As an example, assume that I purchase an anesthesia machine for 50, 000, that the manufacturer allows me to pay for it in five equal installments of 10, 000 each, and that the first payment is due 1 yr after I receive the machine. Then, because of the principle of discounting, the “true cost” of the machine is not 50, 000, but rather 43, 294, if the discount rate is 5% (Figure 2). In any medical economic analysis it is essential that future cost be appropriately discounted to the present value. The third major issue to understand about costs is that they are different when viewed from different perspectives. Therefore whose perspective should we adopt? Any author of an economic analysis should carefully and consistently consider the perspective of the analysis. Costs can be examined from the perspectives of the society, patient, provider, and payer. Each perspective has its merits, although in general I would argue that the most appropriate perspective is either the provider or the society. The recommendation of the US Public Health Service Panel on Cost-Effectiveness in Health and Medicine is that all published cost-effectiveness analyses include an analysis from the perspective of society. 8 The societal perspective is the most general, but it also is the most difficult and may not provide the best answers to specific questions. For example, if the question concerns the cost of administering antiemetic medication to patients having surgery, then the best perspective for examining the cost is the provider's. It is important that the author of a medical economic study explicitly identify the perspective of the study. The cost to society is the net cost of all the different components of society, including the patient's lost productivity and the expenses involved in giving and receiving medical care. This is the broadest perspective taken, and for health policy decisions it is probably the best. It is, however, difficult to enumerate and appropriately quantify all of the costs to society. The cost to the provider, such as a hospital or a physician, is the true cost of providing a service, regardless of the charge, and few medical institutions are prepared to identify their true economic costs. 4, 9 The provider's perspective is appropriate if the cost of producing health care is being examined. It is, however, difficult to determine true cost. Industrial engineering and time-motion studies are often necessary for this kind of cost accounting. If time-motion studies are performed correctly they can be useful: To understand and control costs, it is best to understand and control the activities that incur costs. Time-motion studies are expensive, however, and require significant effort and commitment from everyone involved in the study. An alternative to performing detailed time-motion studies is to calculate certain aggregate performance indicators such as the cost-to-charge ratio, which converts hospital charges to hospital costs. This ratio paints broad strokes rather than fine detail, but it may be easier to estimate this number than to perform a detailed time-motion study. In fact, for many medical economic studies, the cost-to-charge ratio may be the only mechanism available to estimate production costs. An essential concept from this perspective is that charges do not necessarily equal costs. 9 The cost of producing a certain medical service may be more or less than charges that are levied for the service. Rarely is the charge equal to the production cost. A brief example can clarify this important point. The present acquisition cost to my hospital for a 1-l bag of lactated Ringers IV solution is 0. 86, but the charge to a patient is 36. 00. What is the cost of administering a liter of this solution to a patient? Certainly the true cost to the hospital is greater than the acquisition cost because the hospital must store and process the intravenous fluid, and a nurse (or an anesthesiologist) must prepare and administer the fluid. However, the hospital financial officer readily concedes that other services (such as linen and housekeeping) are subsidized by the excess charge for intravenous fluids. The practice of subsidizing one part of the hospital from excess revenues generated in another part of the hospital is common. This means that patient charges for a given service may not equal the cost of producing the service. The concept of the inequality of costs and charges raises another important issue related to provider costs. To compute the cost to the hospital or other provider for rendering a medical service, certain overhead costs must be added to the acquisition cost of the products involved. In the case of administering a liter of intravenous fluid, it was determined that, at a minimum, overhead costs include processing and storing the fluid as well as preparing and administering the fluid. How should this overhead cost be determined and allocated to a given liter of intravenous fluid? There are no hard and fast rules. The key idea is that overhead allocation affects costs. Some overhead allocation will be arbitrary. Rules used to allocate overhead to the various activities involved in providing a medical service must be explicit in any economic analysis so that readers can judge for themselves whether the allocation makes sense. The perspective of the patient may be appropriate if the question is patient welfare. From a patient's perspective, his or her cost is the amount he or she pays for the service (the amount over and above that covered by insurance), plus any other costs that might be incurred because of illness and treatment, including time missed from work. From the perspective of the payer, costs equal charges that are allowed by the specific payer. This perspective generally is not useful unless the economics of the insurance industry are being examined. The last issue relating to the concept of costs is which costs should be counted. There is truth to the saying “All that counts can't be counted, and not all that can be counted counts. ” Although the perspective taken determines the specific costs that are counted, four general categories of costs are useful in organizing any examination of costs. These four categories are direct medical costs, direct nonmedical costs, indirect costs, and intangible costs. The four categories are expanded in Table 1. Some of these costs, particularly the intangible ones, are difficult to quantify and value. Once a perspective for costing is selected and the categories of costs to be included in the study are determined, then authors of a medical economic study should carefully aggregate the costs while paying attention to the concepts already discussed regarding total, marginal, and average costs and appropriate discounting of future costs and savings. Typically the total cost is the appropriate measure to determine. However, as in the rest of cost determination, context determines the appropriate measure. The aggregate or net health resource cost is the cost that is used in economic analysis. The components of net health resource cost are presented in Table 2. Most of what has been said about costs could also be said about benefits. Benefits must be viewed from either the perspective of society, the provider, the patient, or the payer. The natural beneficiaries for a medical economic study are either the society or the patient. The type of benefit must be specified-either direct medical, direct nonmedical, indirect, or intangible. Future benefits must be discounted to obtain the present value. For health-care policy studies, the benefits to be determined are usually the benefits that accrue to the entire society. 3 Societal benefits can be difficult to measure with completeness and accuracy. For the typical medical study, patient benefits are the focus. In fact, because the patient's benefits are a part of the society's benefits, and because for anesthesiology-type benefits the patient's benefits are the only truly identifiable ones, they may be the same. For the purpose of a patient-centered study, it is essential to identify the health outcomes generated by the medical service or procedure that is being investigated. Clinical endpoints are not comparable across all disease states or across all medical interventions. The benefits that accrue from an anesthesiologist's medical intervention (see, for example, Table 3) may be different than those that accrue to a surgical or medical intervention (see, for example, Table 4). Because quality-adjusted life-years (QALYs) are used in many medical studies outside of anesthesiology, 10 and an anesthesiologist may not be comfortable with the concept of the QALY, I briefly discuss the concept. In a study that reports benefits as a QALY, numeric weights are assigned to each possible health state. These weights range from 1 (perfect health) to 0 (equivalent to death) and reflect relative preferences of the affected population. There are many ways to obtain the preference weights used in a QALY determination. 7 For example, the following weights can be assigned to the indicated health states: side effects of hypertension treatment = 0. 98; mild angina = 0. 90; moderate angina = 0. 70; severe angina = 0. 50. 11 The weight of 0. 5 for severe angina means that a group of patients believe that 1 yr of life with severe angina is only as good as one-half year of life in a healthy state. The duration of time in each health state is multiplied by its weight, and the sum of weight times duration equals QALYs. The idea of the QALY makes explicit the preferences of patients for quality of life, not just life. According to Russell et al. , 8“since the purpose of investing in health is to make people better-off, it seems appropriate to be the judge of what or outcomes and of the relative of health The of a measure of the quality of life is in an article by et in which the authors with compared the expected outcome for with the expected outcome for In their analysis of in a of of life but when were for quality of life, in a of quality-adjusted is an of all medical economic How benefits are however, determines the type of economic study. Three basic types of economic study are common to the medical cost-identification analysis, cost-effectiveness analysis, and cost-benefit all benefits are then cost-identification analysis is the appropriate type of study. analysis is analysis. This is one of the most common types of study in the If a difference in outcome is not the but rather the cost of comparable outcomes is, then a of the costs of each is The for this analysis is to the way to the example, if A and are at and and both have a side and if the issue is which to then the appropriate analysis is cost The in this is to be the The analysis does however, address the question of whether we should the money for either in of other possible of our example from the literature used cost as an et examined three for having were assigned to receive either with by maintenance with and with by maintenance with and or 3) with by maintenance with and The authors that there was no difference in outcome for patients to receive any of the The cost for the three however, The cost of 1 was more than that for 2, which was more than that for however, that that study the value of the hospital charges the cost of The cost of was one of the outcome benefits are measured but are not to monetary then cost-effectiveness analysis is This the that one could outcome in exchange for the of more The is not just cost In this either the measured health outcomes are used or outcomes are into a common the of analysis, such as the QALY discussed analysis is used to two or more treatment cost-effectiveness analyses must state explicitly which two interventions are being the costs for the two treatment are determined, and the outcomes from the two are to a common then a ratio can be for each treatment A typical ratio might be dollars per in dollars per decreased of or dollars per The for the two treatment then can be used to determine which treatment the most benefit for a given investment of has been As et is not for cost analysis is used to examine that cost money rather than The also more than being because a treatment has been to be does not that it is the should not be only to those treatment that money with an equal or health outcome when compared with other Although these types of treatment are such a of the is to be analysis has been used in many different which has to confusion. According to Russell et can be difficult to and are often presented in a way that rather than in the health effects and costs included and in the way these are and so that studies of the same intervention can different cost-effectiveness may be and that can be to any of this for the US Public Health Service the Panel on in Health and Medicine in The of this available in and it makes many specific for cost-effectiveness analysis was used to examine issues important to I the for patients who are for and the of for patients to be a study to assess the cost-effectiveness of four for the of patients who are for et that for the of the of and by for is with the of and and has a cost-effectiveness a study by et that examined the benefit of for in patients, with was a and treatment in a of cost-effectiveness analysis has an important in economic studies, not all are with the argue that the rational by cost-effectiveness analysis are not to who their as well as their in and treatment A study that those in medical often a policy that they as more than would be produced by to cost-effectiveness analysis. benefits are to monetary then cost-benefit analysis is the appropriate analysis is useful to but it does not explicitly determine whether the outcomes are worth the costs. analysis this comparison by costs and benefits in the same difference between cost-effectiveness analysis and cost-benefit analysis can be a example taken from and two treatment treatment A and treatment The cost for treatment A is and the cost for treatment is A patient's life with treatment A is yr, it is yr with treatment The of the of life in a given health state is by the weights assigned to life after each treatment for A and for treatment A in x yr, or and treatment in x or is to perform a cost-effectiveness analysis. A costs 10, 000 more than treatment and in 1 year of life, or the cost-effectiveness ratio for treatment A compared with treatment is 10, 000 per or per QALY a cost-benefit analysis, the must be into a dollar which is a difficult a QALY into a dollar a of value and not all this will the same of This can be by examining a patient's to pay for a certain or by the patient's or as a measure of The surrounding the of health outcomes into dollar few true cost-benefit analyses have been For the of assume that the benefits from treatment A are worth and the benefits from treatment are worth these the cost-benefit ratio is and the benefits of treatment A are worth the analyses and cost-benefit analyses be to in the that we have in other of medical of the analysis and be to The that should be performed is analysis. A analysis the to which in the cost and benefit could the of the a analysis, the (such as the cost of the specific are allowed to from those that are measured in the study, and the cost-effectiveness or cost-benefit are If the variable can assume a range of the from the ratio then we can have more that the are in the are to a change in the then we can have less in the from the medical economic analyses should have at least a analysis in which the for the important are one at a time. A quality economic analysis might also have a analysis in which the key are allowed to at the same time. A analysis is important if of the key are understanding of the concepts of costs and benefits is essential for performing any medical economic analysis. any author of a medical economic study must which perspective patient, payer, to in the analysis. It is essential that this perspective be the analysis and that it be to the the author of the analysis must which costs and benefits to in the analysis medical, direct nonmedical, indirect, Future costs and benefits must be discounted with costs and is common to all medical economic It is difficult to costs accurately. of an economic analysis must make the case that the appropriate costs were included and that overhead costs are allocated to the various cost are also difficult to measure with but they are difficult to value. If benefits are to be equivalent for the being then a cost-identification analysis is The in this analysis is to costs. If benefits are measured and to a common and then cost-effectiveness analysis can be used to two treatment If benefits are measured and into dollar then cost-benefit analysis can be performed. of benefits into dollar is more or less and generally who perform these types of economic analyses and those who must be with the I have To be of these basic principles is to be less to understand and to criticize the growing of literature relating to medical economic analysis.