Using the theory of multiproduct cost functions, this paper derives a cost function for physically frail older people living in private households, based on data collected between 1991 and 1995, for 472 subjects aged 65 years of age or over in four areas of England. The main characteristic of the cost function is that output categories are classified in terms of movements between different health states. These were measured by changes in activities of daily living (ADL) over 2 years, with 'low' ADL representing better functional ability than 'high' ADL. Empirical application of the approach, using four states defined in terms of worsening progression (stable low ADL; deteriorated or improved ADL; stable high ADL; deceased), indicated more favourable states were associated with lower costs. Multivariate analysis showed that the derived states were significantly related to costs which, when combined with variables indicating presence of particular chronic health conditions (diabetes or previous stroke), admission to continuing care accommodation and household structure, explained one-fifth of the variation in log average costs per week. Variables such as age, sex, carer input, social networks and level of cognitive functioning had no independent impact on costs. These findings could be used as a starting point for those interested in predicting the cost implications associated with the ageing population.