A cost plus reimbursement contract is an agreement in which the client pays the contractor back for every allowable expense on a project and then pays a separately negotiated fee on top as profit. It exists for work that cannot be priced accurately at the start, so instead of guessing at a total, the client agrees to cover actual costs as they come in. The structure shows up most often in federal procurement, aerospace and defense, and residential construction where the full scope only becomes visible once work is underway.
How the Two Payment Streams Work
Every cost plus contract has two sides. The reimbursement side covers the contractor’s qualifying expenses: labor, materials, equipment rental, and so on, billed with supporting documentation. The fee side is the contractor’s profit, a separate line item fixed in the contract before any work starts. The method for calculating that fee varies by contract type, but it is always distinct from the costs being reimbursed.
Because the final price depends on what the work actually costs, the client carries most of the financial risk. The contractor is made whole on expenses even if the project runs over. That tradeoff is the point: it lets a client get work started when they cannot write a specification tight enough for a contractor to quote a firm price.
Federal rules reflect that logic. The Federal Acquisition Regulation permits cost-reimbursement contracts only when the agency either cannot define its requirements well enough for a fixed-price arrangement or faces uncertainties that prevent accurate cost estimation.1Acquisition.GOV. 48 CFR 16.301-2 – Application Agencies also have to clear additional hurdles before awarding one: the contractor’s accounting system must be adequate for tracking costs at the contract level, the agency must have enough staff to oversee performance, and a written acquisition plan must be approved above the contracting officer. Cost-reimbursement contracts are prohibited outright for purchases of commercial products and services.2Acquisition.GOV. 48 CFR 16.301-3 – Limitations
What Costs Get Reimbursed
Not every dollar a contractor spends qualifies. The rules around which expenses the client has to pay back are detailed, especially on government work.
Direct and Indirect Costs
Direct costs are tied specifically to the contract: wages for people assigned to the project, materials consumed, equipment rented for the work. These get billed straight to the contract with timesheets, purchase orders, and receiving reports.
Indirect costs are shared expenses that benefit more than one contract or the business as a whole, like facility rent, utilities, IT, and the salaries of executives and administrative staff. Because you cannot assign them to a single project, contractors calculate an indirect cost rate (often called an overhead rate) as a percentage of a direct cost base and apply it across contracts. On federal work, final indirect cost rates are established at the end of the fiscal year through either a contracting officer determination or an auditor determination.3Acquisition.GOV. 48 CFR 42.705 – Final Indirect Cost Rates
Since contractors cannot wait until year-end to bill overhead, they use provisional billing rates during the year, set based on recent audits, prior-year experience, or other reliable data. The goal is for provisional rates to land close to the eventual final rates. Either party can request an adjustment, and if they cannot agree, the contracting officer can set the rate unilaterally. After year-end, the provisional rates get trued up through audit and negotiation, with the difference settled as either additional payment or a refund.4Acquisition.GOV. 48 CFR 42.704 – Billing Rates
Allowable Versus Unallowable Costs
Even a reasonable business expense can be ineligible. To qualify under the FAR, a cost must be reasonable, allocable to the contract, consistent with Cost Accounting Standards (or GAAP where CAS does not apply), permitted under the contract terms, and not excluded by any specific cost principle.5Acquisition.GOV. 48 CFR 31.201-2 – Determining Allowability
Some categories are always unallowable regardless of how routine they look. Entertainment expenses, including tickets, social outings, country club meals, lodging and transportation tied to entertainment, and club memberships, cannot be reimbursed.6Acquisition.GOV. 48 CFR 31.205-14 – Entertainment Costs Lobbying and political activity, including campaign contributions, lobbying legislators, and organizing public campaigns to influence legislation, are also excluded.7Acquisition.GOV. 48 CFR 31.205-22 – Lobbying and Political Activity Costs Fines and penalties from violations of federal, state, local, or foreign law are unallowable, with a narrow exception for fines incurred because of specific contract terms or written direction from the contracting officer.8Acquisition.GOV. 48 CFR 31.205-15 – Fines, Penalties, and Mischarging Costs
Including unallowable costs in a reimbursement claim can get those charges disallowed and, in serious cases, trigger penalties for mischarging. The contracting officer can also disallow any claimed cost that lacks adequate supporting documentation.5Acquisition.GOV. 48 CFR 31.201-2 – Determining Allowability
How the Fee Gets Calculated
The “plus” side of the contract is the contractor’s profit, and the way that profit is calculated creates very different incentives.
Cost-Plus-Fixed-Fee
A cost-plus-fixed-fee (CPFF) contract sets a dollar fee at the start, and that number does not move. If the work runs over budget, the contractor still collects the same fee. If it comes in under, the fee is still the same. The FAR describes CPFF as suitable for research, preliminary studies, or development and test work where the level of effort is unknown and an incentive-fee arrangement is not practical.9Acquisition.GOV. 48 CFR 16.306 – Cost-Plus-Fixed-Fee Contracts It is the most common cost-reimbursement arrangement in federal contracting. There is little incentive for the contractor to control costs, but the structure also avoids rewarding cost growth the way a percentage-based fee would.
Federal law caps the CPFF fee based on the contract’s estimated cost, excluding the fee itself:
- 15 percent for experimental, developmental, or research work
- 10 percent for all other cost-plus-fixed-fee contracts
- 6 percent of estimated construction cost for architect-engineer services on public works
These are ceilings, not targets. Contracting officers negotiate fees below the limits using a structured profit analysis that weighs contractor risk, investment, and performance history.10Acquisition.GOV. 48 CFR 15.404-4 – Profit
Cost-Plus-Incentive-Fee
A cost-plus-incentive-fee (CPIF) contract starts with a target cost and an initial fee, then adjusts the fee up or down using a formula tied to how actual costs compare to the target. Beat the target, the fee grows. Overrun, the fee shrinks. The formula is negotiated upfront, usually with a minimum and maximum fee to cap both reward and penalty.11Acquisition.GOV. 48 CFR 16.304 – Cost-Plus-Incentive-Fee Contracts The share ratio in the formula determines how aggressively the incentive bites: a 70/30 government/contractor split means the contractor keeps 30 cents of every dollar saved below target and absorbs 30 cents of every dollar of overrun.
Cost-Plus-Award-Fee
A cost-plus-award-fee (CPAF) contract splits the fee into a base amount (which can be zero) fixed at the start and an award pool distributed based on a subjective evaluation of the contractor’s performance. A government evaluation board periodically reviews the work and decides how much of the pool to pay out.12Acquisition.GOV. 48 CFR 16.305 – Cost-Plus-Award-Fee Contracts This structure works when the client wants to incentivize dimensions hard to reduce to a formula, like technical quality, responsiveness, or management effectiveness. The tradeoff is subjectivity: reasonable people can disagree about whether performance was excellent or merely satisfactory.
Cost-Plus-Percentage-of-Cost: Banned in Federal Contracts
Under a cost-plus-percentage-of-cost (CPPC) arrangement, the fee is a fixed percentage of total costs. The incentive runs the wrong way: the more the contractor spends, the more they earn. Federal law prohibits CPPC contracting outright. Under 10 U.S.C. § 3322 for defense and 41 U.S.C. § 3905 for civilian agencies, the system may not be used, and the FAR extends the prohibition to subcontracts.13Acquisition.GOV. 48 CFR 16.102 – Policies CPPC contracts remain legal in the private sector, and they appear regularly in home construction, which is where the mismatched incentive catches most people off guard.
Cost Plus Contracts in Home Construction
Outside of government work, cost plus arrangements are most common in home building and renovation. The mechanic is the same: the homeowner pays for all labor and materials at actual cost, plus a markup covering the contractor’s overhead and profit. A contractor might frame it as “for every dollar we spend on your project, we charge $1.15,” meaning a 15 percent markup on costs.
The appeal for homeowners is transparency. You see every receipt. There is no hidden margin baked into inflated material quotes, and if the project comes in cheaper than expected, you pay less. The tradeoff is uncertainty. Because the final price depends on actual costs, you cannot know the total until the work is done. On renovations, where surprises behind walls are routine, that makes budgeting difficult.
A few protections are worth negotiating before you sign:
- A guaranteed maximum price (GMP) that caps total reimbursable costs, with the contractor absorbing anything above the ceiling.
- Itemized invoices with receipts at regular intervals, not a lump sum at the end of each month.
- A written pre-approval requirement for any single expense above a set threshold, such as $500 or $1,000.
Without these guardrails, cost plus construction contracts carry real risk of overruns, especially with the percentage-of-cost fee structure that is banned in federal work but perfectly legal between private parties.
Documentation and Audit Expectations
The administrative burden on a cost plus contract is heavier than on a fixed-price deal because every dollar has to be documented, categorized, and justified. Contractors typically submit detailed invoices monthly, breaking out direct labor by person and hours, direct materials by item and purchase order, and indirect costs using the applicable billing rates. Each submission has to separate reimbursable costs from the fee being requested.
On federal contracts, indirect cost proposals require a formal certification that all costs are allowable and that nothing expressly unallowable is included. That certification carries legal weight; a knowingly false statement can trigger fraud penalties.14Acquisition.GOV. 48 CFR 52.242-4 – Certification of Final Indirect Costs
Every claimed cost needs proof. Direct labor needs auditable time records showing which project and task each employee worked on, approved by a supervisor. Materials need vendor invoices, purchase orders, and receiving reports tying each item to the contract. Indirect costs need documentation of the allocation methodology and the underlying expenses feeding into the rate calculation.5Acquisition.GOV. 48 CFR 31.201-2 – Determining Allowability Contractors must retain these records for at least three years after final payment.15Acquisition.GOV. 48 CFR Subpart 4.7 – Contractor Records Retention
The government has a broad right to examine and audit all records related to cost-reimbursement contracts, including physical inspection of the contractor’s facilities, covering any costs claimed or anticipated.16Acquisition.GOV. 48 CFR 52.215-2 – Audit and Records-Negotiation For Department of Defense contracts, the Defense Contract Audit Agency handles most cost auditing, with the incurred cost audit being the one that settles the contractor’s final indirect rates for a given fiscal year. Disorganized records are the fastest way to have legitimate costs disallowed.
How It Compares to Fixed-Price and Time and Materials
Cost plus makes more sense once you see the alternatives and how risk shifts between them.
A fixed-price contract sets the total price before work begins. If the contractor finishes for less, the savings are profit; if costs overrun, the contractor absorbs the loss. The risk picture is the mirror image of a cost plus arrangement, with the contractor carrying nearly all the financial exposure and the client knowing the price from day one. Fixed-price works best when the scope is well-defined and both sides can estimate costs with confidence.
A time and materials (T&M) contract sits between the two. The client pays a fixed hourly rate for each labor category, with that rate bundling wages, overhead, and profit into a single number. Materials are reimbursed at cost.17Acquisition.GOV. 48 CFR 16.601 – Time-and-Materials Contracts The structural difference from cost plus is where the profit lives: in T&M it is embedded in the hourly rate, while in cost plus it is a separate fee calculated independently from the costs. T&M is common for short-term professional services where labor hours are uncertain but the hourly value of each skill category is known.
The choice comes down to how well the work can be defined upfront. Clear scope and known risks point to fixed-price. Murky scope with uncertain technical challenges points to cost plus. Variable effort with predictable unit costs points to T&M. No structure is inherently better; the question is which one matches the uncertainty of the project at hand.