Indirect Cost Rate for Government Contracts

An indirect cost rate pools overhead (rent, utilities, supervision, administration) and charges it to federal contracts as a percentage of allowable direct costs. The rate is negotiated or self-computed under the Federal Acquisition Regulation (FAR), applied during contract performance, and reconciled against actual costs at project completion — ensuring the government pays a fair share of overhead without overpayment.

Why government contracts require a separate rate

Federal contractors cannot simply charge actual overhead to each contract; the government needs a uniform, auditable mechanism for cost recovery. An indirect rate serves three purposes: (1) it allows the government to know in advance how much overhead will be charged per dollar of direct work; (2) it ensures all contracts share overhead fairly, not just the ones that happen to be active at period end; and (3) it enables auditing, since the rate and its cost basis are documented and negotiated.

Without a rate, a contractor might allocate $500,000 in annual overhead unevenly across contracts, with some bearing far more than their fair share. The indirect rate forces consistency.

Computing an indirect cost rate: Basic framework

Step 1: Identify the indirect cost pool. All overhead costs that benefit multiple contracts flow into one or more pools. Common pools:

• Fringe benefits (payroll taxes, health insurance, retirement).
• Facilities (rent, utilities, maintenance, property taxes).
• General and administrative (executive salaries, finance, HR, insurance, audit).
• Information technology.

Some contractors use a single overhead pool; larger firms may use department-level pools to match overhead to where work is performed.

Step 2: Assign costs to the pool. Collect all allowable indirect costs for the fiscal period. Unallowable costs (lobbying, certain entertainment, fines) are excluded.

Step 3: Choose an allocation base. Common bases are:

• Total allowable direct costs. Overhead as a percentage of all contract labor, materials, and subcontractors.
• Direct labor dollars. Overhead as a percentage of direct wages only.
• Direct labor hours. Overhead as a dollar amount per direct labor hour.

The base should reflect how overhead is consumed. A labor-heavy contractor might use direct labor dollars; a capital-intensive one might use total direct costs.

Step 4: Calculate the rate. Divide the total indirect costs by the total allocation base.

Step 5: Apply to contracts. On each federal contract, multiply the contract’s allowable direct costs (or labor hours) by the rate.

Worked example: Engineering firm with one overhead pool

A consulting firm performs research and engineering work under federal contracts and commercial projects. The firm wants to compute a provisional indirect cost rate for the upcoming fiscal year.

Projected annual indirect costs (allowable):

Projected allocation base (allowable direct costs):

Calculate the rate:

Indirect rate = $820,000 ÷ $2,500,000 = 32.8%

This means the firm will charge 32.8 cents of overhead for every dollar of direct cost charged to a contract.

Apply to a contract. A federal research contract incurs:

• Direct labor: $100,000
• Materials: $20,000
• Subcontractors: $10,000
• Total direct costs: $130,000

Indirect cost charged: $130,000 × 32.8% = $42,640

Total billed to contract: $172,640 ($130,000 direct + $42,640 indirect).

Provisional versus final rates

Contractors typically work under a provisional indirect rate for nine or ten months, then reconcile at year-end against actual costs. The provisional rate is an estimate; it may be revised if actual overhead differs from the projection.

At fiscal year-end, the contractor computes the final indirect rate based on actual costs and actual allocation base. If the final rate (say, 31.5%) is lower than the provisional (32.8%), the contractor owes the government a refund for the over-billing on all federal contracts during the year. If the final rate is higher (say, 35%), the government owes the contractor an adjustment.

This reconciliation is called the true-up or final indirect cost rate adjustment. It must be completed within set timeframes (typically 120 days after fiscal year-end for most contractors) and is subject to audit.

Allowable and unallowable costs under FAR

Not all overhead can be charged to federal contracts. The FAR and OMB Uniform Guidance (2 CFR Part 200) specify allowable and unallowable costs. Allowable costs are reasonable, necessary, and allocable to the contract. Unallowable costs include:

• Lobbying and political contributions.
• Fines, penalties, and legal settlements (except those directly benefiting contract performance).
• Entertainment and certain meals.
• Donations and charitable contributions.
• Certain advertising and promotional expenses.
• Bad debts.
• Some components of executive compensation (if deemed unreasonable).

A contractor must segregate unallowable costs and exclude them from the indirect cost pool. If unallowable costs are mixed in, the firm risks audit disallowance and repayment.

Multi-pool and function-based allocation

Large contractors often use multiple indirect cost pools, each with its own rate. For example:

• Pool 1 (Facilities): Rent, utilities, facilities staff. Base: square footage or direct labor hours in each location.
• Pool 2 (General and Administrative): Executive, finance, HR. Base: total direct costs.
• Pool 3 (Information Technology): IT infrastructure and support. Base: direct labor hours or total direct costs.

Each pool has its own rate, and the contract is charged using all three rates — a more granular and defensible allocation when departments have different cost structures.

Cognizant agency role

Most federal contractors have a cognizant federal agency — the agency responsible for auditing and negotiating the contractor’s indirect costs. This is typically the agency from which the contractor receives the most federal funding, or it defaults to the Department of Health and Human Services.

The contractor and cognizant agency negotiate an indirect cost rate agreement (ICRA), which is binding for a multi-year period. The contractor cannot unilaterally change the rate; deviations must be negotiated and documented.

Contractors without a cognizant agency (or those new to federal contracting) may compute a provisional rate themselves and submit it to the awarding agency, which then verifies it during audit.

Common issues and red flags

Over-allocation. A contractor sets an indirect rate that is too high, charging the government more than fair share of overhead. This triggers audit findings and potentially disallowance.

Unallowable costs in the pool. Lobbying, bad debts, or fines inadvertently included in overhead trigger disallowance.

Inconsistent allocation bases. Changing the allocation base mid-year without justification violates FAR requirements and invites scrutiny.

Lack of supporting documentation. A contractor must maintain cost accounting records that substantiate the indirect cost pool and allocation base. Without timesheets, payroll records, and cost categorizations, the rate cannot be audited.

Subcontractor indirect rates. If the prime contractor uses a subcontractor, the subcontractor may have its own indirect cost rate (often higher, since small subs have less economies of scale). The prime contractor must verify the sub’s rate is allowable and consistent.

See also