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The size of a diagnostic test set is significantly larger than the size of a fault detection test set. As a result, fault detection test sets may be used for initial defect diagnosis, and diagnostic tests may be added as needed to narrow down a set of candidate defect sites. Between a fault detection test set and a full diagnostic test set there is a large range of test sets that can be used for improved (initial) diagnosis. This paper describes a diagnostic test generation process that produces such a range of test sets. The process is based on a ranking of the indistinguished fault pairs according to the importance of distinguishing them. The ranking is based on the structural distance between faults. This allows failure analysis to explore fewer and more localized areas of the circuit as the size of the diagnostic test set is increased. This paper also discusses the insertion of observation points to distinguish fault pairs that remain indistinguished by a diagnostic test set. Observation point insertion uses the ranked list of indistinguished fault pairs to ensure that a limited number of observation points will address the fault pairs that are the most important to distinguish.