Indirect Cost Rates for Government Contractors: A Plain-Language Guide

Your employee earns $30 an hour. You bill the government $75. The difference isn’t profit. It’s your indirect cost rates, and if you can’t explain where every dollar goes, the Defense Contract Audit Agency (DCAA) will ask you to explain it under audit.

This isn’t a scare tactic. It’s accounting. Understanding indirect cost rates government contracting firms must track is essential because every legitimate dollar between $30 and $75 represents a real cost your business incurs to stay in operation: taxes, health insurance, rent, software, your own time running the company. The government allows all of it. But you have to track it the right way, categorize it correctly, and calculate your rates using an accepted methodology.

That’s what this guide teaches you. If you’re new to government contracting, start there first.

What Are Indirect Cost Rates?

Indirect costs are the expenses that keep your business running but don’t belong to any single contract. Rent, accounting fees, your own salary as the CEO, payroll taxes, health insurance: none of these costs can be assigned to Contract A or Contract B. They benefit all your work equally. So the Federal Acquisition Regulation (FAR) requires you to distribute them across your contracts using a formula called an indirect cost rate.

The definition in plain English: An indirect cost rate is a percentage that represents the ratio of your indirect expenses to a measurable base (like direct labor). You apply that percentage to every contract to recover your overhead and administrative costs. Per FAR 31.203, an indirect cost is “any cost not directly identified with a single final cost objective.”

The formula is simple:

Rate = Pool / Base

The “pool” is the total of all indirect costs in a category. The “base” is the total of the direct costs you’ll use to allocate those indirect costs. Divide one by the other and you get your rate as a percentage.

Here’s why this matters: your indirect rates are the difference between winning a contract and losing money on it. If your true fully-loaded cost is $68 per hour and you bid $60 per hour, you lose $8 on every hour worked. That’s not a cash flow problem. That’s a math problem. And it starts with not knowing your rates.

To set up the accounting system that tracks these costs correctly, see our guide on DCAA-compliant accounting systems for small businesses.

The Three Cost Pools Every Contractor Needs

Most small government contractors need three cost pools: Fringe Benefits, Overhead, and General and Administrative (G&A). Each pool captures a different category of indirect cost, uses a different allocation base, and produces a separate rate. Together, they tell you the full cost of delivering a dollar of direct labor to the government.

Fringe Benefits Pool

Fringe benefits are the employer-paid costs of having employees beyond their base salary. They include Federal Insurance Contributions Act (FICA) payroll taxes (Social Security and Medicare, 7.65% of wages), health and dental insurance, paid time off, 401(k) or retirement plan contributions, workers’ compensation insurance, and disability coverage.

The allocation base for fringe is total labor dollars. That means all labor: both direct employees working on contracts and indirect employees doing administrative work. Because the fringe pool gets spread across all labor, it affects every hour of work your company does.

Overhead Pool

Overhead captures the costs of supporting contract performance that can’t be charged directly to a contract. Project managers who work across multiple projects but aren’t identified to one contract, facility rent, shared IT infrastructure, equipment depreciation, and office supplies all typically live in overhead.

Overhead allocates on direct labor dollars only, not total labor. This is a key distinction. Because you’re allocating overhead only to direct (contract) work, overhead rates tend to run higher than fringe rates at many small firms.

General and Administrative Pool

G&A covers the costs of running the business as a whole: executive leadership, accounting, legal counsel, BD costs, corporate insurance policies, professional memberships, and training that benefits the whole organization rather than a specific project.

G&A uses Total Cost Input (TCI) as its base. TCI equals everything except G&A costs: direct labor, fringe on direct labor, overhead applied to contracts, and direct materials or subcontract costs. Because G&A’s base is the biggest of the three, G&A rates are usually the lowest as a percentage.

Two Pools vs. Three: What’s Right for Your Firm?

Very small service firms, especially those with no indirect labor to speak of, sometimes combine fringe and overhead into a single pool called a “combined fringe/overhead” rate. This works when your indirect structure is simple enough that the two-pool approach doesn’t distort your costs. Most firms with five or more employees benefit from keeping the three-pool structure because it gives you better visibility into where your costs actually live.

Some manufacturing contractors add a fourth pool called Material Handling for costs associated with procuring and managing direct materials. If your business is primarily services, you almost certainly don’t need this pool.

For a deeper look at FAR compliance requirements, see our guide on FAR compliance for small businesses.

How to Calculate Your Rates: A Worked Example

Numbers make this real. Here’s how a $30-per-hour employee becomes a $75-per-hour billing rate using a small service firm with five direct employees and two indirect employees.

The company has total labor of $422,000: five direct employees averaging $62,400 per year ($312,000 total) and two indirect/administrative employees at $55,000 each ($110,000 total).

Step 1: Calculate the Fringe Rate

The fringe pool includes all employer-paid benefit costs for all seven employees.

Fringe Rate = $160,328 / $422,000 total labor = 38%

This means that for every dollar you pay in salaries, you spend an additional $0.38 in fringe benefits. A $30-per-hour employee actually costs you $30 × 1.38 = $41.40 before you’ve recovered a single dollar of overhead.

Step 2: Calculate the Overhead Rate

The overhead pool captures the costs of supporting contract performance that aren’t directly charged to contracts. For this firm, that’s mostly the two indirect employees plus facilities and technology.

Overhead Rate = $188,000 / $312,000 direct labor = 60%

Notice that fringe on indirect labor is in the overhead pool, not the fringe pool. This is correct treatment: the fringe on indirect employees is itself an indirect cost that supports overhead activities.

Step 3: Calculate the G&A Rate

The G&A pool covers the cost of running the business as a whole.

The G&A base is Total Cost Input: everything except G&A. For this firm, TCI = direct labor ($312,000) + fringe on direct labor ($118,560) + overhead applied ($188,000) = $618,560.

G&A Rate = $78,600 / $618,560 = approximately 12.7%, which rounds to 13% for billing purposes.

Note: the worked example in the wrap rate table below uses slightly simplified rates (Fringe 38%, Overhead 60%, G&A 15%) to illustrate the full $75 billing rate from the opening. The difference reflects the normal variation in how firms categorize and allocate specific costs. In practice, your accountant or APEX Accelerator counselor can help you determine your firm’s exact rate structure.

Step 4: Build Your Wrap Rate

The wrap rate is your fully loaded cost per dollar of direct labor. It’s the number that tells you whether a contract makes or loses money before you add any profit.

Here’s the complete buildup from a $30-per-hour base salary to a $75.14 billing rate:

Your wrap rate is $2.28 for every dollar of direct labor ($68.31 / $30.00). Bill below $68.31 per hour and you lose money on every hour worked, before profit even enters the picture.

Two things to notice in this table. First, overhead applies to base direct labor only (line 4 is 60% of $30, not 60% of the loaded labor rate in line 3). Second, G&A applies to the subtotal before G&A, which includes direct labor plus fringe plus overhead. Different firms use slightly different conventions for how to apply overhead and G&A, but this Total Cost Input method is the most common approach for service contractors.

On fixed-price contracts, you don’t bill these rates as line items. But you absolutely need them to price your bids correctly. For a deeper look at how pricing differs between contract types, see our guide on cost plus vs. fixed price contracts.

Provisional vs. Final Rates

You bill at provisional rates during the year. You reconcile to actual rates after the year ends. Understanding the difference prevents billing errors and protects you from audit findings.

Provisional Billing Rates

A provisional billing rate is an estimate of what your indirect rate will be for the year, approved by the contracting officer for use during contract performance. You calculate it at the start of each fiscal year based on your budget. Then you bill every cost-reimbursable contract using those provisional rates until the year closes.

Provisional rates let work proceed and let the government reimburse you in real time, even though your actual costs won’t be known until after year-end. Think of them as estimated tax withholding: you pay based on your best estimate throughout the year, then settle up at the end.

Actual Rates and the Reconciliation

After your fiscal year closes, you calculate your actual indirect rates from your real financial records. The actual rates will almost never match your provisional rates exactly. The difference creates a billing adjustment:

• If your provisional rates were higher than actual: you over-billed the government. You owe money back.
• If your provisional rates were lower than actual: the government under-reimbursed you. They owe you additional payment.

The Incurred Cost Submission

Within six months after your fiscal year ends, you must submit an Incurred Cost Submission (ICS) to your administrative contracting officer, per FAR 52.216-7. Calendar-year contractors (fiscal year ending December 31) must submit by June 30. This submission presents your actual costs, calculates your final rates, and documents the over- or under-billing adjustment.

DCAA has developed the Incurred Cost Electronically (ICE) model: a free Excel-based template that formats your submission correctly. Download it from the DCAA website and use it. Submissions that don’t follow the standard format create extra work for auditors and can trigger additional scrutiny.

The Rate Lifecycle

Understanding where your rates are in their lifecycle helps you manage billing and audit risk.

1. Budget rates: Internal estimates used for proposal pricing before a contract is awarded.
2. Forward pricing rates: Negotiated with the contracting officer for future contract pricing. Used on larger, multi-year programs.
3. Provisional billing rates: Approved estimates used for invoicing during contract performance.
4. Actual rates: Calculated from real costs after fiscal year close.
5. Settled rates: Agreed final rates after DCAA audit or administrative settlement. This closes out the rate year.

For most small contractors, you’ll deal primarily with provisional billing rates and actual rates. The others become relevant as your firm grows into larger, multi-year cost-reimbursable programs.

To set up the accounting infrastructure that tracks these rates properly, see our guide on DCAA-compliant accounting systems for small businesses.

Costs You Can Never Include

FAR 31.205 lists 46 cost categories with specific rules. Some costs are expressly unallowable. You cannot include them in any indirect pool and bill them to the government, directly or indirectly.

The executive compensation cap for calendar year (CY) 2025 is $671,000. Any compensation above that amount for your five highest-paid employees cannot be included in any indirect pool. This cap applies to total compensation, not just salary: bonuses, stock, deferred compensation, and other forms of remuneration all count toward the limit.

The penalty for charging unallowable costs to government contracts is significant. Under FAR 42.709, the government can assess a penalty equal to two times the disallowed amount, plus interest. The fix is simple: segregate unallowable costs in their own accounts in your chart of accounts from day one. Keep them completely separate from any pool that gets allocated to government contracts.

A good DCAA-compliant accounting system flags unallowable costs automatically. For setup guidance, see our article on DCAA-compliant accounting for small businesses.

When Cost Accounting Standards Apply

Most small businesses are exempt from Cost Accounting Standards (CAS). If you’re reading this article because you’re new to government contracting or running a small firm, CAS probably doesn’t apply to you yet. But understanding the thresholds helps you plan for growth.

CAS is a set of standards developed by the Cost Accounting Standards Board that govern how defense contractors track and allocate costs. The standards are codified at title 48 of the Code of Federal Regulations (CFR), Part 9903. Small businesses are fully exempt, regardless of contract size or dollar value.

For non-small businesses, the fiscal year (FY) 2026 National Defense Authorization Act (NDAA) significantly raised the CAS thresholds, effective after June 30, 2026:

The FY2026 NDAA raised the full CAS coverage threshold from $50 million to $100 million and the per-contract trigger from $2.5 million to $35 million. These increases reduce the compliance burden for mid-tier contractors significantly.

If you do reach Modified CAS coverage, the four applicable standards in plain English are: CAS 401 (apply your accounting practices consistently), CAS 402 (treat the same cost the same way across all contracts), CAS 405 (identify and exclude unallowable costs from your pools), and CAS 406 (use the same fiscal year consistently for cost accounting).

For a complete picture of your size status and what thresholds apply to your business, see our guide on SBA size standards.

Five First-Year Mistakes That Trigger Audit Findings

The Defense Contract Audit Agency reported $15.9 billion in audit exceptions in fiscal year (FY) 2024. Most problems at small firms trace back to a small number of errors made in the first year of government contracting. Here are the five most common.

1. Charging Leave as Direct Labor

An employee takes a sick day or vacation. Someone records those hours as direct labor on a specific contract. This is wrong. Leave time is a fringe benefit. It belongs in the fringe pool and gets recovered through your fringe rate, not by billing it to a specific contract.

Charging leave as direct labor isn’t just an accounting error. It can constitute a false claim under the False Claims Act if it inflates your contract billing. Set up your timekeeping system with dedicated leave codes from day one. Make sure every employee knows the difference between direct time (time worked on contract tasks) and indirect time (leave, training, internal meetings).

2. Inconsistent Cost Classification

The same type of cost must be treated the same way across all contracts. If you charge a project manager’s time as direct labor on Contract A, you cannot charge a similar project manager’s time as indirect (overhead) labor on Contract B. This is a core principle of both FAR 31.203 and CAS (if applicable).

DCAA auditors look for this pattern specifically. Document your cost classification policy in writing. Define which roles are always direct, which are always indirect, and how you handle roles that could be either. Apply the policy consistently before you have contracts, not after an auditor asks about it.

3. Burying Unallowable Costs in Indirect Pools

Took a client out to dinner and threw it in the entertainment budget? That’s an unallowable cost under FAR 31.205-14. If that entertainment cost is in your G&A pool, you’re effectively billing it to the government through your G&A rate. That’s the problem DCAA auditors find most often at small firms.

The fix: create dedicated general ledger accounts for unallowable costs and code them there from the moment the expense is incurred. These accounts must be completely separate from any pool that feeds into your indirect rates. “Unallowable entertainment,” “unallowable lobbying,” and “unallowable executive comp over cap” should be line items in your chart of accounts.

4. Using Provisional Rates as Final Rates

At fiscal year-end, some contractors simply close their books without reconciling provisional billing rates to actual costs. They treat the provisional rate as if it were the final rate and move on. This creates two problems: it leaves potential over-billings unaddressed (which can become false claims), and it means the Incurred Cost Submission never gets prepared and filed.

Mark the ICS deadline in your calendar when you sign your first cost-reimbursable contract. Calendar-year contractors: June 30 is the annual deadline. Build time into your budget for the year-end reconciliation work. It takes a few days the first year and gets faster as the process becomes routine.

5. Missing the Incurred Cost Submission Deadline

The Incurred Cost Submission is due within six months after your fiscal year ends, per FAR 52.216-7. Missing this deadline creates administrative problems with your contracting officer and can result in DCAA flagging your accounting system as inadequate. It also delays the final settlement of your billing rates, which means you may not collect the full amount owed to you on under-billed contracts.

Use DCAA’s ICE model. Start preparing the submission one to two months before the deadline. Have your CPA or GovCon accountant review it before you file. A complete, accurate ICS on time is one of the simplest ways to signal to the government that your accounting system is under control.

For more on setting up an accounting system that prevents all five of these errors, see our guide on DCAA-compliant accounting systems for small businesses.