What Is an Indirect Cost Rate? How Does My Organization Get One?

An indirect cost rate is a ratio of indirect and direct costs that is approved by your cognizant federal agency which you are allowed to use in budgets in future governmental contracts. There are several words in that sentence that I think we need to define before discussing anything else.

#1 – Your organization’s cognizant agency is the federal department with the largest dollar amount of direct federal awards. Federal funding received through another agency, such as a state or city government agency, does not count towards this determination.

#2 – Indirect costs are expenses your organization incurs for activities that cannot be specifically identified with a project or program. Examples of these expenses are operations, maintenance, depreciation, legal, IT, accounting, auditing, etc. Other terms that you might recognize as indirect costs are overhead costs, administration costs, and facilities costs.

Your organization is eligible to apply for an indirect cost rate if you have a direct federal award (already issued and final – not pending) and the award’s budget allows for indirect costs. To receive an indirect cost rate, the organization submits a proposal to its cognizant agency. Some agencies provide examples of such proposals; DHHS Division of Cost Allocation handles a lot of proposals and has examples as well as the checklists that its people use to approve the proposals on its website.

The proposal will need to include your organization’s allocation method for indirect costs. There are three methods that you can use. The important thing to remember is to keep it as simple as possible and to not go outside of your organization’s comfort zone in developing the allocation method. You will need to be able to explain and possibly defend your method; and if it is too complicated, you might not be successful in obtaining the rate.

The simple method is used when significant functions benefit from the indirect costs in the same degree. Using this method there is only one pool of costs you have to allocate according to one base which results in only one rate. Your base should be appropriate for your organization and should be adjusted for any costs that your funding sources do not allow under their contracts.

The multiple allocation base method is used when the functions benefit in varying degrees. The best way to explain this is with an example: If your organization conducts research in 2 labs but one of the labs requires complete darkness and the other requires lights on 24 hours a day, then those two functions use electricity differently but utilize rental space the same way. This results in two different allocation bases for rent and electricity.

The last method is the direct allocation method which involves the organization allocating as much as reasonably possible directly to the programs, leaving only the bare bones administrative expenses that cannot be feasibly allocated directly. Under the other two methods, the indirect cost pool would include things like rent, IT, telephone, etc. Under the direct allocation method, these expenses would be allocated directly to the functions using square footage, number of employees or number of telephones. Then the remaining indirect costs are allocated based on the rate calculated.

Having an indirect cost rate is beneficial for an organization because it can use the cost rate in proposals for all types of grants and contracts funded by governmental agencies. Under the new OMB Uniform Guidance, all sources awarding federal monies (directly or indirectly) to your organization must accept your indirect cost rate if you have one approved. It is also beneficial to have an indirect cost rate that is in line with the actual indirect costs that the organization incurs (and not an arbitrary number inserted into a budget), so that the organization can recover as much as possible.