Compensation Reasonableness: How to Document and Defend Pay Under FAR 31.205-6

Two contractors pay their lead engineer $185,000. Both operate in the same metro area. Both hold cost-reimbursement contracts with the Department of Defense. When DCAA opens an incurred cost audit, the first contractor pulls a compensation file: three salary surveys, a job description matching duties to BLS occupational codes, board minutes approving the salary, and a geographic adjustment calculation. The auditor reviews it in 40 minutes and moves on.

The second contractor has nothing. No surveys. No job description. No documented rationale. The salary is identical, the qualifications are identical, and the market rate supports $185,000. None of that matters. Without documentation, DCAA questions the entire amount. The associated fringe benefits on the full salary become questioned costs too: another $55,000 to $65,000 in health insurance, retirement match, and payroll taxes. Same salary. Different outcomes.

Compensation reasonableness is not about paying your people less. It is about proving you paid them the right amount. Amerifusion Bookkeeping builds compensation files for GovCon contractors because FAR 31.205-6 puts the burden of proof on the contractor, not DCAA. The auditor does not have to prove your compensation is unreasonable. You have to prove it is reasonable.

What Compensation Reasonableness Means Under FAR 31.205-6

FAR 31.205-6(b) defines six factors DCAA uses to evaluate whether contractor compensation is reasonable: comparable pay in the same industry, comparable pay in the same geographic area, the contractor’s overall compensation practices, the contractor’s financial condition, the individual’s qualifications and performance, and labor market conditions. An auditor weighs all six factors together. No single factor controls the outcome.

Most contractors assume “reasonable” means “at or below the median.” Two landmark cases destroyed this assumption. In J.F. Taylor, Inc. (ASBCA, 2012), the board called DCAA’s methodology “statistically incorrect and fatally flawed” because auditors used BLS median data as a ceiling without adjusting for contractor-specific factors. In Metron, Inc. (ASBCA, 2012), the board overturned $1.3 million in questioned compensation costs after reviewing the contractor’s documented methodology.

The lesson from both cases: above-median pay is not automatically unreasonable. Undocumented pay is automatically unsupported.

The Executive Compensation Cap: $695,000 in 2026

Federal law caps the amount of employee compensation contractors charge to government contracts. For 2026, the cap is $695,000 per employee annually [FAR 31.205-6(p)]. Any compensation above this threshold is unallowable, regardless of how well it is documented. The cap applies to total compensation: salary, bonuses, deferred compensation, and employer contributions to retirement plans.

The cap has risen steadily since the Bipartisan Budget Act of 2013 changed the calculation methodology to use the BLS Employment Cost Index:

Contracts awarded before January 1, 2012 follow an older, lower benchmark (around $260,000, varying by year). If your firm holds both pre-2012 and post-2012 contracts, track two separate cap thresholds. Charging above the applicable cap on either track creates an unallowable cost finding.

How to Conduct a Compensation Reasonableness Study

A compensation reasonableness study matches each position in your company to external market data, applies adjustments for geography and qualifications, and documents the rationale in a file DCAA reviewers will accept. Complete this study for every position, not only executives or highly paid employees. DCAA auditors sample across all salary levels.

Step 1: Select salary survey sources. Use at least two independent sources per position. DCAA-accepted sources include:

• Bureau of Labor Statistics (BLS) Occupational Employment and Wage Statistics (free, updated annually)
• Economic Research Institute (ERI) for geographic-specific salary data
• Mercer compensation benchmarks for industry comparisons
• Professional association surveys from groups like NCMA or AIA

Step 2: Match positions by duties, not titles. A “Program Manager” at a 20-person security firm performs different work than a “Program Manager” at Lockheed Martin. Match the actual job duties, education requirements, supervisory responsibilities, and required certifications to the survey’s occupational descriptions. A title mismatch gives the auditor grounds to reject your entire comparison.

Step 3: Apply documented adjustments. Raw survey data rarely matches your exact situation. Three adjustments are standard:

1. Geographic adjustment: BLS data is national. If you operate in the Washington, D.C. metro area, salaries run 15% to 25% above national medians. Document the specific locality pay factor.
2. Clearance premium: Employees holding active security clearances command a 10% to 20% premium over non-cleared equivalents. Reference the ClearanceJobs or ClearEdge salary surveys as supporting data.
3. Company size adjustment: Small firms (under 100 employees) often pay higher per-person rates to attract talent away from larger competitors. Document this with size-stratified survey data.

Step 4: Build the file and get management approval. Record the analysis in a written memo. Include the survey data, the adjustment calculations, and the final determination. Have the CEO, owner, or board of directors sign the memo approving the compensation levels. An unsigned analysis is a draft, not a decision.

Step 5: Update annually. Refresh salary surveys each fiscal year. Document any compensation changes with the supporting rationale. Maintain the file for three years beyond contract closeout per DCAA record retention requirements.

The Fringe Benefit Trap

When DCAA finds compensation unreasonable or above the cap, the questioned amount is not limited to the excess salary. Every fringe benefit calculated as a percentage of compensation becomes partially unallowable too. This is the cost multiplier most contractors miss until the audit report arrives.

Here is how it works. Assume an employee earns $750,000 in total compensation against the 2026 cap of $695,000. The $55,000 excess is unallowable. Your fringe rate is 35%. The fringe benefits associated with the excess ($55,000 times 0.35 = $19,250) are also unallowable. The true cost of a $55,000 overage is $74,250.

This multiplier effect applies to every fringe component calculated on compensation: employer FICA, health insurance allocated per-employee-dollar, 401(k) matching, and employer retirement contributions. The math compounds fast. For a firm with 5 employees above the cap, a $55,000 excess per person generates $371,250 in total questioned costs, not $275,000.

Owner Compensation: The Highest-Risk Category

Small business owners who serve as employees face the toughest scrutiny on compensation reasonableness. The owner sets their own salary, approves their own bonus, and controls the board. DCAA knows this. Auditors apply extra skepticism to owner compensation because no independent check exists unless the contractor builds one. This is one of the first areas reviewed in a DCAA compliance audit.

Three rules protect owner compensation during an audit:

1. Separate salary from profit distributions. Owner compensation is a cost charged to contracts. Profit distributions are a return on equity. If an owner pays themselves $400,000 in salary and takes $200,000 in distributions, only the $400,000 flows through indirect rates. Mixing the two creates an immediate finding.
2. Benchmark against the position, not the person. DCAA compares owner pay to market rates for the job the owner performs. If the owner functions as CFO, the benchmark is CFO pay for a firm of similar size, location, and contract volume. “I own the company” is not a recognized pay factor under FAR 31.205-6.
3. Document board-level approval. Even in a single-owner LLC, create an annual resolution documenting the compensation decision. Record the survey data reviewed, the adjustments applied, and the final amount approved. This resolution becomes the centerpiece of the audit file.

Bonus and Incentive Compensation Documentation

Bonuses are allowable under FAR 31.205-6(f), but only when tied to documented performance criteria established before the performance period begins. A year-end bonus announced in December based on criteria invented in December is a discretionary payment, not an incentive. DCAA treats the distinction as a bright line.

Four documentation requirements protect bonus allowability:

1. Written bonus plan: The plan must exist before the performance period starts. It defines who is eligible, what metrics trigger payouts, and how amounts are calculated.
2. Performance criteria: Revenue targets, project milestones, utilization rates, or customer satisfaction scores. “Good performance” is not a criterion. “95% or higher on-time delivery rate” is.
3. Individual evaluations: Each bonus recipient needs a written evaluation showing how their performance measured against the established criteria.
4. Timely payment: Accrue bonuses in the fiscal year earned. Pay them within a reasonable period after year-end. A bonus earned in FY2025 but paid in September 2026 raises timing questions under the accrual rules.

Year-end profit distributions disguised as bonuses are a persistent audit target. If 80% of the “bonus pool” goes to two owners, DCAA will reclassify the payment as a distribution, making it unallowable against government contracts.

The Compensation File: What DCAA Expects to See

Every position in your company should have a compensation file containing specific documents. When the auditor requests compensation support, you hand over the file. No searching. No compiling. No excuses. Here is what belongs in each file:

Retain these files for three years beyond final contract closeout. For a five-year contract, the file lives eight years minimum. DCAA record retention requirements under FAR 31.205 make this non-negotiable.

Frequently Asked Questions

Key Takeaways

• The burden sits with you. DCAA does not prove compensation is unreasonable. Your documentation proves it is reasonable, or the cost is questioned. Build the file before the audit notification arrives.
• Above-median pay is defensible. The J.F. Taylor and Metron cases confirm auditors cannot use median salary data as a ceiling. Document why the position warrants above-median compensation (geography, clearance, specialized skills), and the pay stands.
• The fringe multiplier catches contractors off guard. Excess compensation at a 35% fringe rate turns a salary overage into a significantly larger total finding. Calculate total exposure, not salary exposure alone.
• Owner compensation requires extra structure: separate salary from distributions, benchmark against the role performed, and create board resolutions even in single-owner firms.
• Run your compliance readiness check to identify whether your compensation files meet DCAA standards. If the files are empty, Amerifusion’s DCAA compliance team builds them from scratch: salary surveys, adjustment calculations, management memos, and annual update schedules.

Compensation reasonableness is one of the most audited cost categories in government contracting. The contractors who survive these audits share one trait: they built the file before DCAA asked for it. Start with your five highest-paid employees. Pull two salary surveys per position from BLS and one commercial source. Document the adjustments. Get the memo signed. The entire process takes a day per position. A questioned cost finding on six figures of compensation takes months to resolve and costs far more than a day of preparation. Schedule a consultation to get your compensation files audit-ready.