Government policy-making should be more focused on the social and personal wellbeing of citizens, as opposed to viewing economic growth as the prime measure of a country's progress, influential former Whitehall supremo, Gus O'Donnell, has advised.

An independent commission chaired by Lord O'Donnell, who served three prime ministers as Cabinet Secretary from 2005 until his retirement at the end of 2012, finds the current system of cost benefit analysis is incapable of evaluating goods and services that do not have market prices – or reflect the value people place in them.

Health, social care and law and order were among key policy areas the Legatum Institute's report, entitled Wellbeing and Policy, found were short-changed by economic modelling.

The report concluded mental health should be treated as professionally as physical ill health.

It also recommended parents should be given greater support with the emotional and physical aspects of child rearing, and that schools should explicitly teach children life skills and promote character building.

At community level, government policy should support volunteering, address loneliness and create a built environment that is sociable and green, the commission urged.

The prime objective of economic policy should be to reduce volatility, even at the cost of stunting average growth rates, because a fall in income is shown to lower wellbeing more than an equal boost in income increases it, the report advises.

Lord O'Donnell stepped down as head of the civil service, Cabinet Secretary and permanent secretary at the Cabinet Office at the end of a 32-year civil service career.