Every year about 22 billion pounds is allocated to health authorities for hospital and community services in England. The distribution of most of these funds is based on a formula developed to reflect the population's needs, but the existing formula has been criticised on several grounds. This paper describes the development of a method to determine the health needs for small geographical areas. Data from the hospital episodes statistics and 1991 census together with information on vital statistics and supply of health care facilities were used in the model. Two stage least squares regression was used to identify true indicators of need, and these were entered into a multilevel model to take account of variations in practice in different health authorities. The resulting formula should be more statistically robust and more sensitive to needs than previous approaches.