Indirect Cost Rates for Government Contracts: A Setup Guide

Indirect cost rates are the financial backbone of cost-reimbursement contracting. They determine how you allocate overhead costs to your government contracts, how much you can invoice, and how your cost accounting system will withstand DCAA scrutiny.

Many small contractors approach indirect rates informally — a single "overhead" percentage applied to all contracts. This works for commercial business. It fails for government contracts and creates audit exposure that can result in rate adjustments, cost disallowances, and in severe cases, demand letters for repayment.

This guide explains the standard indirect rate pool structure and how to set it up correctly.

What Are Indirect Costs?

Direct costs are costs that benefit a specific contract and can be identified to that contract: the salary of an employee working on Contract A, materials purchased for Contract B.

Indirect costs are costs that benefit multiple contracts or the business as a whole and cannot be directly assigned to a single contract: rent, utilities, accounting, management salaries, employee benefits, corporate IT systems.

The government's problem with indirect costs: if you simply charge overhead to the contract that can absorb it, you could manipulate which contracts bear the most cost burden. Indirect cost rates solve this by requiring you to allocate indirect costs consistently, based on a rational relationship between the cost pool and the allocation base.

FAR 31.201-4 requires that indirect costs be accumulated in pools and allocated to cost objectives (contracts) using bases that represent the beneficial relationship between the costs and the work.

The Standard Three-Pool Structure

Most government contractors use a three-pool indirect cost structure:

Pool 1: Fringe Benefits

What it is: Employee-related costs that benefit all employees: FICA, FUTA, SUTA, health insurance, life insurance, dental, vision, retirement contributions, workers' compensation.

Allocation base: Usually direct labor dollars (or sometimes total labor dollars including indirect labor).

Fringe rate calculation:

Fringe Rate = Total Fringe Benefits / Total Labor Dollars

Example: If you pay $500,000 in total fringe benefits and have $2,000,000 in total labor, your fringe rate is 25%.

When you charge a direct labor cost to a contract, you also charge 25% fringe on top of it. A $100/hour employee costs the contract $125/hour.

Pool 2: Overhead

What it is: Costs that support the production/performance of contracts but don't benefit the overall company: project management support, technical training, small tools and supplies used on projects, direct project facilities, fringe on direct labor if not separately pooled.

Allocation base: Direct labor dollars is standard.

Overhead rate calculation:

Overhead Rate = Overhead Pool Total / Direct Labor Base

Some contractors have multiple overhead pools if they have distinct cost centers (e.g., a separate manufacturing overhead pool and a services overhead pool). The key is that each pool's costs have a rational relationship to the pool's allocation base.

Pool 3: General and Administrative (G&A)

What it is: Costs that manage the overall business and cannot be practically allocated to specific projects: CEO and CFO salaries, corporate office rent, accounting and legal, business development, insurance, corporate IT.

Allocation base: Total Cost Input (TCI) — the sum of all direct and indirect costs before G&A — is the most common and DCAA-preferred base. Some contractors use total revenue or value-added (total costs minus subcontracting pass-throughs).

G&A rate calculation:

G&A Rate = G&A Pool Total / Total Cost Input

Example: If your G&A costs are $300,000 and your TCI is $3,000,000, your G&A rate is 10%.

How Rates Work on an Invoice

A cost-reimbursement contract will have provisional billing rates approved in advance. These are estimates of what your actual rates will be — used to invoice during the year.

For a $100/hour direct labor employee:

• Direct Labor: $100.00
• Fringe (25%): $25.00
• Overhead (30%): $30.00
• G&A (10% of TCI): $15.50 (10% of $155.00)
• Total Billed: $170.50

At the end of the year, you calculate your actual rates based on actual costs. The difference between provisional billing rates and actual rates is trued up in your Incurred Cost Submission (ICS), which is submitted to DCAA within 6 months of fiscal year end.

Provisional vs. Final vs. Forward Pricing Rates

Provisional Billing Rates (PBRs): Estimated rates used for billing during the contract year. Established by agreement with the ACO (Administrative Contracting Officer) or by DCAA rate recommendations.

Final Indirect Cost Rates: Rates calculated at year end based on actual costs. The difference between provisional rates and final rates determines whether you owe money back to the government (overbilling) or are owed additional payment (underbilling).

Forward Pricing Rate Agreements (FPRAs): Negotiated rates used for cost proposals on new contracts. Unlike PBRs (which are for billing), FPRAs are for proposal pricing. Large contractors typically negotiate FPRAs annually with DCAA.

Cost Accounting Standards (CAS)

CAS (48 C.F.R. Chapter 99) is a set of cost accounting rules that apply to government contractors above certain thresholds:

• CAS Coverage triggers at: Single award of $2 million or more on a negotiated contract (subject to exceptions)
• Full CAS Coverage applies at: $50 million or more in CAS-covered contracts in a single year

CAS requires consistency in cost accounting practices — you cannot change how you allocate indirect costs from year to year without following the CAS Disclosure Statement amendment process. CAS changes that increase charges to the government require equitable adjustment negotiations.

Small businesses typically qualify for CAS exemption until contract values exceed the applicable thresholds. But your accounting practices must still be consistent and allocable under FAR Part 31.

Unallowable Costs: What You Cannot Charge

FAR 31.201-2 defines the standards for cost allowability. Even if a cost is legitimate business expenditure, certain costs are unallowable on government contracts:

Unallowable costs must be segregated in your accounting system — tracked separately but not charged to government contracts. DCAA auditors look for unallowable costs billed to contracts as a primary audit focus.

Setting Up a DCAA-Compliant Accounting System

A "DCAA-compliant" accounting system is one that meets the requirements of FAR 16.301-3 for cost-reimbursement contracts:

Key requirements:

• Segregates direct costs from indirect costs
• Identifies and accumulates indirect costs in pools
• Identifies unallowable costs separately
• Provides a complete audit trail for all charges
• Captures actual costs by contract

Common accounting software used:

• QuickBooks (with GovCon add-ons like Procas, Unanet QuickBooks)
• Unanet (purpose-built for govcon)
• Deltek Costpoint (enterprise, large contractors)
• JAMIS (cloud-based govcon)

Standard QuickBooks alone is typically insufficient for DCAA compliance at the job-cost level. Work with a govcon-experienced accountant to configure your chart of accounts and reporting structure before your first cost-reimbursement award.

The Incurred Cost Submission (ICS)

Every contractor with a cost-reimbursement contract must submit an Incurred Cost Submission within 6 months of fiscal year end. The ICS:

• Calculates actual indirect rates for the year
• Compares actual rates to provisional billing rates
• Reconciles any over/underbilling

DCAA then selects ICS submissions for audit. Deficiencies in the ICS — missing schedules, unsupported costs, inconsistent treatment — trigger deeper audits.

Submit a complete, correctly formatted ICS on time. DCAA provides sample formats. A govcon accountant or CPA familiar with the ICS requirements is essential.

Key Takeaways

• Three-pool structure (Fringe → Overhead → G&A) is the standard for government contractors; each pool must have a rational allocation base.
• G&A uses Total Cost Input as its allocation base in most DCAA-preferred accounting structures.
• Provisional billing rates are estimates used for invoicing during the year; final rates reconcile at year end via the Incurred Cost Submission.
• Unallowable costs (entertainment, lobbying, alcohol, excess compensation) must be segregated and never charged to government contracts.
• CAS coverage applies above $2M in negotiated contracts — full CAS at $50M. Small businesses are often exempt but must still apply consistent cost accounting.
• DCAA-compliant accounting software (Unanet, Costpoint, or properly configured QuickBooks) is a prerequisite for cost-reimbursement contracting.

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