Cost-Reimbursement Contracts: Types, Fee Caps, and Allowable Costs

Cost-reimbursement contracts pay a contractor for actual, verified expenses rather than a pre-negotiated lump sum, up to a government-set cost ceiling, with a separate fee paid as profit on top. They are the standard procurement tool when a project’s scope is too uncertain to price in advance.¹ They appear most often in defense research, complex IT modernization, and other work where the path from start to finish carries real technical or financial unknowns.

When Agencies Can Use This Contract Type

A contracting officer cannot pick this structure just because it seems flexible. The Federal Acquisition Regulation limits cost-reimbursement contracts to two situations: the agency cannot define its requirements well enough for a fixed-price contract, or the uncertainties in performance make it impossible to estimate costs accurately enough for a fixed price.² Research and development is the classic case. When nobody knows whether a prototype will work on the third attempt or the thirtieth, locking in a price would either bankrupt the contractor or force the government to pay a heavy risk premium.

The regulation also demands that the agency have enough technical and administrative staff to monitor spending in real time. Without active surveillance, a cost-reimbursement contract becomes a blank check. The contracting officer must determine upfront that oversight will be adequate, and the contractor’s accounting system must be capable of tracking costs at a level the government can audit.²

The Structure That Is Always Prohibited

One arrangement is banned outright across federal procurement. A cost-plus-a-percentage-of-cost contract, where the contractor’s fee grows automatically as spending increases, creates a direct incentive to spend more. Both the defense and civilian procurement statutes prohibit it.³⁴ Every legitimate cost-reimbursement structure ties the fee to something other than raw spending: a fixed dollar amount, a performance formula, or a subjective evaluation by the government.

Types of Cost-Reimbursement Contracts

Several variations exist. The right choice depends on how predictable the work is and how strongly the government wants to reward cost control.

Cost-Plus-Fixed-Fee

A cost-plus-fixed-fee (CPFF) contract sets the contractor’s profit as a specific dollar amount negotiated at the start. That fee stays the same whether the project comes in under budget or runs to the ceiling, and it changes only if the government formally modifies the scope of work.⁵ Because the fee neither rewards efficiency nor penalizes waste, CPFF suits exploratory research where cost outcomes are genuinely unpredictable.

Cost-Plus-Incentive-Fee

A cost-plus-incentive-fee (CPIF) contract gives the contractor a financial stake in cost outcomes. The parties negotiate a target cost, a target fee, and a sharing formula that splits any savings or overruns. Finish below target, and the contractor keeps a share of the savings as additional profit. Exceed target, and the fee shrinks according to the same formula. The contract sets a minimum fee (which can be zero) and a maximum fee, so the adjustment runs within guardrails.¹

Cost-Plus-Award-Fee

A cost-plus-award-fee (CPAF) contract combines a base fee (sometimes zero) with an additional award fee the government determines through subjective evaluation. A fee-determination board typically meets at set intervals to assess quality, schedule, and technical performance, then decides how much of the available award fee the contractor earned.⁶ The structure rewards excellence a formula cannot capture, at the cost of heavier administration and the risk of disputes over subjective judgments.

Cost and Cost-Sharing Contracts

Not every cost-reimbursement contract carries a fee. A straight cost contract reimburses allowable expenses but pays no profit, and is common with nonprofit research institutions and universities.⁷ A cost-sharing contract goes further: the contractor absorbs some of the costs and receives no fee, usually because the work produces knowledge or technology the contractor expects to benefit from commercially.⁸

Statutory Fee Caps

Federal law caps how much profit a contractor can earn under any cost-plus-fixed-fee contract. The limits vary by the type of work:

Research, development, or experimental work: the fee cannot exceed 15 percent of the estimated cost, excluding the fee itself.
Architectural or engineering services for a public work: the fee plus the contractor’s cost for those services cannot exceed 6 percent of the estimated project cost.
All other CPFF contracts: the fee cannot exceed 10 percent of the estimated cost, excluding the fee.

These ceilings come from statute, and the agency head makes the estimated-cost determination at the time the contract is signed.³ The same caps appear in the FAR’s contract pricing rules.⁹ The 6 percent limit on architectural and engineering work is the one contractors most often overlook.

Accounting System Requirements

A contractor cannot receive a cost-reimbursement award without first proving its accounting system can handle the tracking the government demands.¹⁰ The system must separate direct costs from indirect costs, and it must identify unallowable costs so they never appear on a government invoice.

The government evaluates these capabilities through a pre-award survey on Standard Form 1408. The system has to track labor by contract through timekeeping and labor distribution, accumulate costs under general ledger control, allocate indirect costs consistently, produce interim cost data at least monthly, and support pricing for follow-on work. Contractors whose systems are still being built must explain what exists and what remains.¹¹ Failing the review is a dealbreaker: no adequate system, no award. Larger contractors also face Cost Accounting Standards, which impose stricter consistency requirements on how costs are estimated, accumulated, and reported.¹²

Which Costs Actually Get Reimbursed

The government does not reimburse every dollar the contractor spends. FAR Part 31.2 sets out the standards each cost must meet.¹³ A cost is reasonable if it reflects what a careful businessperson would pay under similar circumstances. A cost is allocable to a contract if it was incurred specifically for that contract, or if it benefits the business generally and can be distributed proportionally. Auditors apply both tests line by line, and costs that fail either get disallowed.

Some categories are flatly unallowable regardless of reasonableness: entertainment, alcoholic beverages, lobbying, interest and financing costs, and goods or services purchased for personal use. The FAR lists dozens of specific items with detailed rules, and expenses treated as normal in the commercial world often turn out to be on the prohibited list.

Indirect Cost Allocation

Indirect costs such as facility rent, executive salaries, and IT infrastructure benefit multiple contracts and cannot be charged directly to any one of them. Contractors group these expenses into pools and distribute each pool across contracts using an allocation base that reflects the actual benefit each contract received.¹⁴ Common bases include direct labor hours, direct labor dollars, or total direct costs. Once the government accepts a base, the contractor cannot cherry-pick out of it: every item properly included must carry its share of indirect costs, even if some of those items are later disallowed. Separate cost pools are required for offsite locations when combining them would distort the distribution.

Cost Ceiling Notifications

The Limitation of Cost clause is the government’s early-warning system against overruns. The contractor must notify the contracting officer in writing whenever costs expected over the next 60 days, combined with all costs already incurred, would exceed 75 percent of the estimated cost in the contract. The notice must also estimate how much more funding the contractor will need to finish the work.¹⁵ This is a contractual obligation, not a suggestion.

For incrementally funded contracts, a parallel Limitation of Funds clause applies. The trigger is the same 75 percent threshold with the same 60-day forward calculation, and 60 days before the end of the funded performance period, the contractor must tell the contracting officer how much more money is needed to continue. The 60-day window can be set anywhere from 30 to 90 days, and the 75 percent threshold can be raised as high as 85 percent, depending on the contract.¹⁶

Work performed past the funded ceiling is at the contractor’s own risk. If the government does not increase funding, the contractor has no obligation to keep working, and the government has no obligation to pay for work done above the limit. A government employee who encourages the contractor to keep working without available funds violates the Antideficiency Act and faces potential civil or criminal penalties.¹⁷

Subcontracting Consent Rules

Prime contractors on cost-reimbursement contracts face tighter subcontracting rules than fixed-price primes. If the prime does not have an approved purchasing system, the government must consent to most subcontracts before award. That covers all cost-reimbursement, time-and-materials, and labor-hour subcontracts, plus fixed-price subcontracts exceeding the greater of the simplified acquisition threshold ($350,000 as of 2025) or 5 percent of the prime contract’s total estimated cost.¹⁸

Even with an approved purchasing system, the contracting officer can require individual consent for subcontracts involving critical systems, components, or services, or whenever the type, complexity, or value warrants special oversight.¹⁸ Prime contractors need to build consent timelines into their procurement schedules, because a slow consent review can hold up the whole project.

Audits and Record Retention

The Defense Contract Audit Agency is the primary auditor for cost-reimbursement contracts, though other agencies run their own audit functions. Contractors must submit an incurred cost proposal within six months after the end of their fiscal year, covering all costs claimed under government contracts during that period. DCAA policy calls for completing the audit within one year of receiving an adequate submission, though backlogs sometimes push that out.¹⁹

Contractors must keep records, materials, and supporting documentation available for government examination until three years after final payment on the contract. If the contract is terminated, the clock resets to three years after the final termination settlement. Records tied to disputes, litigation, or unsettled claims must be preserved until those matters are fully resolved, regardless of the three-year window.²⁰ Destroying records early is one of the fastest ways to turn a routine audit into an investigation.

Termination

The government can terminate a cost-reimbursement contract either for convenience (the work is no longer needed) or for default (the contractor failed to perform). In either case, settlement focuses on reimbursing allowable costs incurred up to the termination date, plus any fee adjustment.²¹

A termination for default requires 10 days’ written notice. The contractor still receives reimbursement for allowable costs, but the total fee is reduced and the costs of preparing the settlement proposal are not reimbursable. After termination, the contractor has six months to submit remaining costs through standard vouchers, and one year from the effective date to submit a final settlement proposal covering any unvouchered costs and the proposed fee. Missing the one-year deadline without an extension from the termination contracting officer can jeopardize the contractor’s ability to recover what it is owed.²¹

1
Acquisition.gov. Federal Acquisition Regulation Subpart 16.3 – Cost-Reimbursement Contracts
2
Acquisition.gov. FAR 16.301-2 Application
3
Office of the Law Revision Counsel. 10 US Code 3322 – Cost Contracts
4
Office of the Law Revision Counsel. 41 US Code 3905 – Cost Contracts
5
eCFR. 48 CFR 16.306 – Cost-Plus-Fixed-Fee Contracts
6
Acquisition.gov. FAR 16.305 – Cost-Plus-Award-Fee Contracts
7
eCFR. 48 CFR 16.302 – Cost Contracts
8
Acquisition.gov. FAR 16.303 – Cost-Sharing Contracts
9
eCFR. 48 CFR Part 15 Subpart 15.4 – Contract Pricing – Section: 15.404-4 Profit
10
eCFR. 48 CFR 16.301-3 – Limitations
11
General Services Administration. Standard Form 1408 – Pre-Award Survey of Prospective Contractor Accounting System
12
eCFR. 48 CFR Part 9904 – Cost Accounting Standards
13
eCFR. 48 CFR Part 31 Subpart 31.2 – Contracts With Commercial Organizations
14
eCFR. 48 CFR 31.203 – Indirect Costs
15
eCFR. 48 CFR 52.232-20 – Limitation of Cost
16
Acquisition.gov. FAR 52.232-22 – Limitation of Funds
17
Acquisition.gov. FAR 32.704 – Limitation of Cost or Funds
18
Acquisition.gov. FAR 44.201-1 – Consent Requirements
19
DCAA. Incurred Cost Submissions
20
eCFR. 48 CFR 52.215-2 – Audit and Records, Negotiation
21
Acquisition.gov. FAR Part 49 – Termination of Contracts