Under FAR Part 31, an allowable cost is one a federal contractor can charge to a government contract because it passes five tests and isn’t blocked by a specific rule; an unallowable cost is one the government won’t reimburse, either because a FAR provision expressly bars it (alcohol, entertainment, interest, lobbying, fines, bad debts, donations) or because it fails on reasonableness, allocability, accounting standards, or the terms of the contract itself. The framework applies to every dollar you bill on a cost-reimbursable, time-and-materials, or labor-hour contract, and it drives the indirect rates you propose each year.
The Five Tests Every Cost Must Pass
FAR 31.201-2 sets out five criteria. A cost is allowable only when it clears all of them:
- Reasonableness — the price is what a prudent businessperson would pay in a competitive market.
- Allocability — the cost has a logical connection to the government work.
- Accounting standards compliance — the expense is recorded under Cost Accounting Standards when CAS applies, or GAAP when it does not.
- Contract terms — nothing in the specific contract prohibits or restricts the charge.
- FAR Subpart 31.2 limitations — the cost is not excluded or capped by any of the detailed cost principles in FAR 31.205 and related sections.
Miss any one test and the cost is disallowed, even if the other four are clean. Auditors from the Defense Contract Audit Agency (DCAA) and other cognizant agencies treat these as a sequential checklist. A charge that looks perfectly reasonable can still be rejected because the contract excludes it or because a FAR provision caps the amount.1eCFR. 48 CFR Subpart 31.2 – Contracts With Commercial Organizations
How Auditors Judge Reasonableness
FAR 31.201-3 defines a cost as reasonable when it does not exceed what a prudent businessperson would pay in a competitive environment. The standard is qualitative. Auditors look at whether the expense is the kind a well-run company would ordinarily incur, whether the contractor followed its own purchasing policies, and whether competitive bids were solicited when appropriate.
Market pricing is the usual benchmark. If comparable goods or services sell in a certain range and your invoice lands well above it without explanation, the government will disallow the overage — not the entire amount, just the portion exceeding what the market supports. Justifications that hold up include sole-source situations, urgent requirements, and specialized expertise that commands a premium.
The burden of proof sits with the contractor. Auditors don’t have to prove a cost is unreasonable; you have to show your spending decisions were logical, market-based, and consistent with how you’d spend your own money. Price comparisons, bid solicitations, and internal approval records make this much easier to demonstrate later.2eCFR. 48 CFR 31.201-3 – Determining Reasonableness
How Auditors Judge Allocability
A cost is allocable when it can be assigned to one or more cost objectives based on the benefit each received. FAR 31.201-4 provides three paths:
- Direct charge, when the cost was incurred specifically for a single contract (materials bought exclusively for one project).
- Shared benefit, when the cost benefits the government contract and other work and can be distributed in reasonable proportion (a testing lab used across multiple projects).
- General business operations, when the cost keeps the company running with no direct tie to a single contract (rent, utilities, corporate administrative salaries recovered as indirect costs).
The government pays only its fair share. If an expense benefits three projects equally, charging the full amount to one government contract will trigger a disallowance.3eCFR. 48 CFR 31.201-4 – Determining Allocability
Direct vs. Indirect and the Consistency Rule
FAR 31.202 requires that any cost specifically identified with a contract be charged directly to that contract. Costs benefiting multiple contracts or the business as a whole are pooled as indirect costs and distributed through overhead or G&A rates. The critical rule is consistency. If you treat a particular type of cost as indirect on some contracts, you cannot cherry-pick and charge the same type of cost directly to another contract where it happens to be more favorable. That rule exists to stop contractors from shifting costs toward contracts with higher reimbursement potential.4eCFR. 48 CFR 31.202 – Direct Costs
A narrow exception exists for minor amounts. A cost that would normally be direct can be treated as indirect when the amount is small, the treatment is applied consistently across all contracts, and the result is substantially the same as charging directly. Think of a $12 box of project-specific labels that costs more to track than it’s worth.
Costs the Government Will Never Reimburse
FAR Subpart 31.205 lists specific categories that are expressly unallowable no matter how reasonable they look or how tightly they tie to the contract. Including any of these in a billing, claim, or rate proposal invites penalties. The most commonly encountered prohibitions:
- Alcoholic beverages (FAR 31.205-51). No exceptions, even at a working dinner.
- Entertainment (FAR 31.205-14). Social activities, sporting events, and similar costs are off-limits even when they involve government personnel.
- Fines and penalties (FAR 31.205-15). Penalties for violating any law at any level of government cannot be billed.
- Bad debts (FAR 31.205-3). Losses from uncollectible receivables are a business risk borne by the contractor.
- Contributions and donations (FAR 31.205-8). Charitable and political donations are unallowable.
- Interest and financing costs (FAR 31.205-20). Interest on borrowings, bond discounts, and the cost of raising capital are unallowable. The government reimburses costs as they are incurred, so contractors shouldn’t need debt to finance performance.5eCFR. 48 CFR 31.205-20 – Interest and Other Financial Costs
- Lobbying and political activity (FAR 31.205-22). Costs aimed at influencing legislation, elections, or executive branch actions are barred.
Some categories are only partly unallowable. Advertising is generally prohibited for image promotion but allowable for recruiting employees or soliciting subcontractors. Legal fees for routine business matters are typically fine, while legal costs for defending against fraud allegations or criminal charges are not. The details within each FAR 31.205 subsection matter, and a blanket assumption in either direction produces errors.
Costs That Are Allowable but Capped
Even costs that aren’t expressly unallowable can be capped or conditioned. Compensation, travel, and professional services are the three areas where contractors most often stumble.
Employee Compensation
FAR 31.205-6 allows compensation for personal services when it is reasonable, tied to work performed in the current period, and consistent with the contractor’s established pay practices. Bonuses and incentive pay are allowable if they follow a plan or agreement that existed before the work was performed and the basis for the award is documented. Pension costs must comply with CAS 9904.412 and 9904.413 and be funded by the deadline for filing the contractor’s federal income tax return. Miss the funding deadline and the pension cost becomes permanently unallowable for that year.6eCFR. 48 CFR 31.205-6 – Compensation for Personal Services
There is also an annual cap. For calendar year 2026, the benchmark compensation amount is $695,000. Any compensation above that threshold for a single employee is unallowable on contracts awarded on or after June 24, 2014. The cap is adjusted each year based on the Employment Cost Index published by the Bureau of Labor Statistics. Agency heads can grant narrow exceptions for scientists, engineers, or other specialists when critical skills are at stake, but those exceptions are rare.
Travel Costs
FAR 31.205-46 caps lodging, meals, and incidental expenses at the federal per diem rates published by GSA for the continental United States, DoD for Alaska and Hawaii, and the State Department for international travel. Spending above these rates is unallowable unless the contractor invokes the “actual expense” method used by federal civilian employees for special or unusual situations. Using that method requires written justification approved by a company officer, and if it becomes a pattern in a particular location, advance approval from the contracting officer is required.7eCFR. 48 CFR 31.205-46 – Travel Costs
Receipts are required for any single expenditure of $75 or more. Every trip must be documented with dates, destination, purpose, and traveler’s name and title. On partial travel days and days with no lodging, the full per diem is not appropriate and the charge must be adjusted downward.
Professional and Consultant Services
Outside professional and consultant fees are allowable under FAR 31.205-33 only with thorough documentation. Contractors must keep the agreement or engagement letter showing scope and rate, invoices detailed enough to identify time spent and services provided, and the consultant’s actual work product such as trip reports, meeting minutes, and deliverables. Retainer arrangements face extra scrutiny: you must show the retainer is necessary, past usage justifies the fee, and the cost compares favorably to building the capability in-house.8eCFR. 48 CFR 31.205-33 – Professional and Consultant Service Costs
IR&D and Bid and Proposal Costs Are Allowable
FAR 31.205-18 treats independent research and development (IR&D) and bid and proposal (B&P) costs as allowable indirect expenses when they are reasonable and allocable. This surprises some contractors: the government does share in the cost of R&D you perform on your own initiative and in the cost of preparing proposals, including proposals for non-government work. The rationale is that these activities maintain the contractor’s technical base and competitive capability.9eCFR. 48 CFR 31.205-18 – Independent Research and Development and Bid and Proposal Costs
IR&D covers basic research, applied research, development, and systems concept studies conducted at the contractor’s own expense. It does not include effort funded by a grant or effort required under an existing contract. B&P covers labor, materials, and overhead spent preparing and submitting proposals, whether solicited or unsolicited. Both are normally allocated through the G&A base. Costs from previous accounting periods are generally unallowable, with a narrow exception for products developed at the contractor’s own risk where development costs can be identified and prorated reasonably across future sales.
Segregating Unallowables, and the Penalty If You Don’t
FAR 31.201-6 requires accounting systems that identify, segregate, and exclude unallowable costs from any billing or indirect cost proposal. This is a structural requirement for cost-reimbursable work, not optional guidance. The system must flag expressly unallowable charges so they never enter indirect cost pools and inflate overhead or G&A rates.10eCFR. 48 CFR 31.201-6 – Accounting for Unallowable Costs
Segregation goes beyond invoices. When an employee spends time on an activity that generates unallowable costs, the salary for that time is a directly associated cost and must also be removed from the allowable pool.
The penalty for getting this wrong is severe. FAR 42.709 imposes a baseline penalty equal to the disallowed amount when expressly unallowable costs end up in a final indirect cost rate proposal. You forfeit the cost and pay an additional amount equal to it. If the contractor knew or should have known the cost was unallowable because of a prior written notice, determination, or agreement, the penalty doubles to twice the disallowed amount. These penalties come on top of interest on any overpayments. That’s why auditors spend disproportionate time examining how well a contractor’s system filters unallowable charges.11eCFR. 48 CFR 42.709 – Penalties for Unallowable Costs
Advance Agreements for the Gray Areas
When a cost is unusual, complex, or likely to draw an argument during audit, FAR 31.109 encourages both parties to negotiate an advance agreement before the cost is incurred. The contractor and contracting officer agree upfront on how a particular expense will be treated, so nobody is caught off guard two years later.12eCFR. 48 CFR 31.109 – Advance Agreements
Advance agreements are not mandatory for any cost, and their absence does not automatically make an expense unallowable. But they are particularly valuable for large relocation moves, charter aircraft, royalties, severance pay on service contracts, IR&D allocation methods, and blended-rate compensation approaches near the annual cap. If your company incurs costs that don’t fit neatly into the standard categories, seeking an advance agreement is one of the most effective ways to protect against after-the-fact disallowances.