Evaluating Labor and Benefit Costs Under FAR 31.205-6
Pricing labor for federal construction requires more than simply totaling wages and standard payroll markups. When costs are scrutinized on government contracts, compensation for personal services must satisfy the strict requirements of Acquisition.GOV FAR 31.205-6. This guide outlines how contractors and estimators can review their wage rates, incentive plans, and employee benefits to ensure every dollar claimed remains allowable.
Step 1: Confirm Timing and Consistency of Compensation
Under federal cost principles, compensation for personal services must be for work performed by the employee in the current year. It cannot represent a retroactive adjustment of prior years' salaries or wages, outside of specific regulatory exceptions. To establish allowability, payments must conform to an established compensation plan or practice that your business follows so consistently that it implies an agreement to make the payment.
If your firm introduces major revisions to an existing compensation plan or launches a brand-new plan, no presumption of allowability exists unless you have provided the cognizant Administrative Contracting Officer (ACO) an opportunity to review the allowability of the changes. This review opportunity must occur either before implementation or within a reasonable period after you put the plan in place.
Step 2: Test Total Compensation Against Reasonableness Benchmarks
Under FAR 31.205-6, the total compensation for individual employees or job classes must be reasonable for the work performed. When compensation is set through arm's-length labor-management agreements negotiated under the Federal Labor Relations Act or similar state statutes, the costs are considered reasonable unless they are unwarranted by the circumstances or discriminatory against the government. For example, applying agreement provisions intended for extremely hazardous activities to a contract involving less hazardous work is unwarranted. An agreement is discriminatory if it results in compensation exceeding what is paid for similar non-government work under comparable circumstances.
For employees not covered by labor-management agreements, contracting officers evaluate reasonableness by looking at whether the sum of each measurable and allowable element totals a reasonable figure. Key factors considered include practices of other businesses:
- Of the same size;
- In the same industry;
- In the same geographic area; and
- Engaged in similar non-government work under comparable circumstances.
When compiling payroll figures, review your true cost structure through our guide on Labor Burden: How to Calculate Your True Hourly Labor Cost to verify that your overhead allocations match standard practice.
Step 3: Document Incentive Pay and Severance Policies
Bonuses and incentive compensation are allowable on federal work, but they must meet strict conditions. The awards must be paid or accrued under an agreement entered into in good faith between your company and the employees before services are rendered, or follow an established policy maintained so consistently as to imply an agreement. Crucially, the basis for the award must be supported by verifiable documentation.
Severance pay represents payments in addition to regular wages for involuntary terminations. To be allowable, severance must be required by law, an employer-employee agreement, an established policy creating an implied agreement, or the specific circumstances of the employment. However, severance is unallowable if workers continue employment with a replacement contractor under substantially equal conditions with credit for prior service, or if they continue working for your firm at another subsidiary, affiliate, or facility.
Step 4: Screen Out Prohibited Equity and Backpay Expenses
Federal rules strictly bar certain forms of compensation. Any compensation calculated or valued based on changes in the price of corporate securitiesâsuch as stock options, phantom stock plans, stock appreciation rights, or junior stock conversionsâis unallowable. Similarly, payments represented by dividend distributions or calculated from dividend payments cannot be charged to federal work. If a contractor pays cash to an employee in lieu of an unallowable stock option or right, that payment is also unallowable.
Backpay is treated as a retroactive adjustment of prior years' wages and is generally unallowable. The exceptions are narrow: payments resulting from underpaid work ordered by a court decree, order, or negotiated settlement; payments to union members working without an agreement during labor negotiations; or payments to nonunion employees following union negotiations where a formal agreement or established policy exists. Keeping these items separated is essential when Pricing Change Orders: A Contractor's Guide to Getting Paid for Extra Work.
Step 5: Apply Special Limits for Company Owners and Family
Federal auditors apply special scrutiny to owners of closely held corporations, partners, sole proprietors, members of limited liability companies, and members of their immediate families, as well as individuals committed to acquiring a substantial financial stake. For these individuals, compensation must be reasonable for the personal services actually rendered and cannot represent a distribution of profits. In addition, compensation for owners of closely held companies is unallowable to the extent it exceeds amounts deductible under the Internal Revenue Code (26 U.S.C.) and its regulations.
Sources
31.205-6 Compensation for personal services. | Acquisition.GOV
Published October 31, 2026. No affiliate links on this page. Facts come from the sources linked above; check them for updates.