Employer contributions to a Health Reimbursement Arrangement are taxed favorably on both sides of the paycheck: the company deducts them as an ordinary business expense and owes no payroll tax on the amount, while the employee receives the contribution tax-free and pays no tax on reimbursements used for qualified medical expenses. That double exclusion is the whole appeal of an HRA, and it holds only as long as the plan follows the IRS rules on funding, use, and structure.
What the Employer Deducts and Saves
An HRA is funded entirely by the employer. Employees cannot put in their own money, and the plan cannot be funded through salary reduction under a cafeteria plan.1Internal Revenue Service. Notice 2002-45 Health Reimbursement Arrangements The company decides each year how much to contribute, which keeps healthcare spending predictable.
Those contributions are deductible as ordinary business expenses and reduce the employer’s taxable income dollar for dollar. They are also exempt from the employer’s share of Social Security and Medicare taxes, which saves roughly 7.65% of every dollar contributed on top of the income tax deduction.2Congressional Research Service. Health Reimbursement Arrangements (HRAs) FUTA does not apply either, because federal law excludes payments for medical or hospitalization expenses from the definition of taxable wages.3Office of the Law Revision Counsel. 26 US Code 3306 – Definitions
What the Employee Owes
Nothing, in the ordinary case. The money the employer puts into your HRA does not show up on your paycheck and is not part of your gross income. Federal law excludes employer-provided coverage under accident and health plans from an employee’s taxable wages.2Congressional Research Service. Health Reimbursement Arrangements (HRAs) No federal income tax, no Social Security tax, no Medicare tax.
When you actually draw on the account, the reimbursements are tax-free too, as long as they pay for qualified medical expenses. The Internal Revenue Code specifically excludes reimbursements paid to an employee for medical care from gross income.4Office of the Law Revision Counsel. 26 USC 105 – Amounts Received Under Accident and Health Plans A dollar of HRA money stretches further than a dollar of wages because none of it is lost to taxes.
What Has to Be True for the Money to Stay Tax-Free
Two conditions carry the whole tax treatment: the expense has to qualify, and you have to be able to prove it.
Qualifying expenses are costs for diagnosing, treating, or preventing disease, and they must primarily address a physical or mental health condition rather than general wellness. Doctor copays, prescription drugs, dental work, vision exams, hearing aids, and inpatient hospital care all count. Since 2020, over-the-counter medications like ibuprofen, allergy pills, and cold medicine qualify without a prescription, as do menstrual care products, provided the employer’s plan documents allow it. Vitamins taken for general health, gym memberships, and cosmetic procedures do not qualify. IRS Publication 502 lists the most common eligible and ineligible items, though it is not exhaustive.5Internal Revenue Service. Publication 502 – Medical and Dental Expenses
Substantiation is the second half. Every claim needs documentation showing the name of the person who received the service, the provider’s name and address, the date, a description of what was provided, and the amount charged. An Explanation of Benefits from your insurer usually captures all of it. A credit card receipt or canceled check does not, because it does not describe the service. For over-the-counter purchases, the receipt must at least identify the specific item. If you cannot substantiate a claim, the reimbursement loses its tax-free status.
When HRA Money Becomes Taxable
Several situations flip the tax treatment on either side.
Non-qualified reimbursements. If an HRA pays you back for something that does not meet the IRS definition of a qualified medical expense, that amount is added to your gross income for the year and taxed like wages. This trips people up with things that feel medical but are not, like teeth whitening or nutritional supplements.
Plan compliance failures. An HRA that fails to satisfy group health plan requirements can trigger an excise tax on the employer of $100 per day for each affected employee.6Office of the Law Revision Counsel. 26 US Code 4980D – Failure to Meet Certain Group Health Plan Requirements The IRS has warned that certain HRA structures that do not comply with health reform requirements are subject to this excise tax.7Internal Revenue Service. IRS Notice 2015-17
Discrimination in favor of highly compensated employees. Because an HRA is a self-insured health plan, it cannot favor highly compensated individuals in eligibility or benefits. The IRS treats someone as highly compensated if they are one of the five highest-paid officers, own more than 10% of the company’s stock, or fall within the top 25% of employees by pay. When a plan discriminates, the penalty lands on the highly compensated employees, not the employer: they lose the income exclusion and some or all of their reimbursements become taxable. Rank-and-file employees keep their tax-free benefits regardless.
Cash-outs. An employer cannot convert an unused HRA balance into a lump-sum payment. If it does, every HRA distribution the employee ever received, not just the cash-out, loses its tax-free status and becomes taxable income. That rule exists to keep HRAs from being used as disguised compensation.
QSEHRA: An Added Condition for Tax-Free Treatment
A Qualified Small Employer HRA is designed for businesses with fewer than 50 full-time equivalent employees that do not offer a group health plan.8Office of the Law Revision Counsel. 26 US Code 9831 – General Exceptions Annual contributions are capped. For 2026, the limit is $6,450 for self-only coverage and $13,100 for family coverage.9Internal Revenue Service. Revenue Procedure 2025-32
QSEHRA reimbursements carry one extra condition that other HRAs do not: they are only tax-free if the employee has minimum essential coverage. Receiving QSEHRA money without qualifying health insurance makes those amounts taxable income. The employer also has to report the total QSEHRA benefit each employee was entitled to receive during the year on Form W-2 in Box 12, using code FF.8Office of the Law Revision Counsel. 26 US Code 9831 – General Exceptions That reporting is informational and does not by itself make the amount taxable.
ICHRA and the Premium Tax Credit
An Individual Coverage HRA lets employers of any size reimburse employees for individual health insurance premiums and other medical expenses, with no federal cap on the annual contribution. The contribution itself is tax-free on the same terms as any other HRA.
The tax wrinkle sits outside the HRA. If your employer offers you an ICHRA that meets the federal affordability standard, you are treated as having an offer of eligible employer-sponsored coverage, which disqualifies you from the premium tax credit on a marketplace plan.10eCFR. 26 CFR 1.36B-2 – Eligibility for Premium Tax Credit That disqualification applies even if you decline the ICHRA. For 2026, an ICHRA is considered affordable if the lowest-cost silver plan in your area, minus the employer’s ICHRA contribution, costs no more than 9.96% of your household income. Employees enrolled in Medicare can use ICHRA funds tax-free for Part A and B premiums, Medicare Advantage premiums, and eligible out-of-pocket costs.
One Note on HSAs
A general-purpose HRA counts as other health coverage that pays expenses before you hit the deductible of a high-deductible health plan, so it disqualifies you from making HSA contributions. Employers can structure limited-purpose, post-deductible, suspended, or retirement HRAs that preserve HSA eligibility. If both are on offer, ask which structure is in place before contributing to the HSA, because contributions made while ineligible are treated as excess and face a 6% penalty for every year the excess remains in the account.