Because lung cancer is a major health care problem in Canada, it is imperative to understand how resources are used to diagnose and treat this disease. This paper describes a method of modelling the direct patient care costs for lung cancer from the perspective of the government as payer in a universal health care system. Clinical algorithms were developed to describe the management of non-small cell (NSCLC) and small cell (SCLC) lung cancer. Patients were allocated to the treatment algorithms in the model based on a knowledge of their distribution by cell type and stage in Canadian cases. A microsimulation model developed by Statistics Canada was used to integrate the data on type of lung cancer, extent of disease, clinical management, survival and health care resource utilization. The direct care costs for diagnosis and treatment of NSCLC ranged from $Cdn 17 889 for the surgery/post-operative radiotherapy treatment of Stages I and II to $Cdn 6333 for supportive care for patients with Stage IV disease. The costs of determining relapse for NSCLC were estimated to be $Cdn 1528 and terminal care costs, made up largely of hospitalization charges and some palliative radiotherapy, were $Cdn 10 331. Direct care costs for the diagnosis and initial treatment of SCLC ranged from $Cdn 18 691 for management of limited stage disease to $Cdn 4739 for the supportive care of patients with extensive disease. The cost of determining relapse for SCLC was estimated to be $Cdn 1590 and terminal care costs averaged $Cdn 9966. For all 15 624 cases of lung cancer diagnosed in Canada in 1988, it was estimated that the total cost of providing treatment and follow-up, and managing relapse over 5 years was $Cdn 328 million. Despite the large total cost of lung cancer management, estimates of cost effectiveness of therapy showed that the cost per life year gained was approximately $Cdn 11 000 for NSCLC and $Cdn 19 560 for SCLC. These estimates of the direct health care costs assume that all patients have access to care, treatment is uncomplicated and practice is standard, and must be viewed as an idealized assessment of the cost of lung cancer management. The microsimulation model, however, does provide a useful framework for evaluating the costs of new diagnostic procedures, treatment strategies and new drugs.