FAR 52.242-3—Penalties for Unallowable Costs.
Plain-English Summary
FAR 52.242-3, Penalties for Unallowable Costs, tells contractors and contracting officers how the Government handles unallowable costs that appear in certain cost submissions. It defines the term “proposal” for this clause, covering a final indirect cost rate proposal and, when applicable, the final statement of costs under an Incentive Price Revision clause. It then explains that contractors may face penalties if they include unallowable indirect costs, especially costs that are expressly unallowable or costs previously determined to be unallowable for that contractor. The clause also ties the penalties to the statutory framework in 10 U.S.C. 3748 or 41 U.S.C. chapter 43 and the implementing rules in FAR 42.709, including how penalties are calculated, when interest applies, and when the contracting officer may waive a penalty. Finally, it makes clear that a penalty payment is not the same as repaying the underlying unallowable cost, and that penalty determinations are final decisions under the Contract Disputes Act. In practice, this clause is a strong compliance and accounting control mechanism: contractors must screen indirect cost submissions carefully, and contracting officers must identify, assess, and document unallowable costs consistently.
Key Rules
Proposal has a narrow meaning
For this clause, “proposal” means either a final indirect cost rate proposal submitted after the fiscal year ends, if it relates to billing-rate payments or final price negotiations, or the final statement of costs under an Incentive Price Revision clause. This definition matters because the penalty rules apply only to these specified submissions.
Unallowable costs must be excluded
The contractor must not include any cost that is unallowable under FAR subpart 2.1 or an executive agency supplement to the FAR. The clause is aimed at indirect costs submitted in proposals, but the prohibition is broad and requires contractors to screen for all unallowable items before submission.
Expressly unallowable costs trigger penalties
If the contracting officer finds a cost is expressly unallowable under a cost principle that specifically addresses allowability of selected costs, the contractor is assessed a penalty equal to the disallowed amount allocated to the contract plus simple interest. Interest is calculated on the amount the contractor was overpaid, using the Treasury rate for each six-month interval.
Previously unallowable costs trigger double penalties
If the contracting officer finds the contractor included a cost that was previously determined to be unallowable for that contractor, the penalty is two times the amount of the disallowed cost allocated to the contract. This is a stronger sanction for repeat inclusion of costs already identified as unallowable.
Penalty determinations are final decisions
Determinations under the penalty provisions are final decisions under the Contract Disputes Act. That means the contractor may challenge them through the disputes process, but the determination itself has legal finality for purposes of the statute and contract administration.
Waiver is possible but limited
The contracting officer may waive penalties only under the criteria in FAR 42.709-6. Waiver is not automatic and must be supported by the regulatory standards; contractors should not assume a waiver will be granted simply because the cost was inadvertent.
Penalty payment is not cost repayment
Paying the assessed penalty does not repay the Government for the underlying unallowable cost if the Government already paid it. The Government may still need to recover the unallowable cost separately, so the penalty is in addition to, not in place of, repayment.
Responsibilities
Contractor
Exclude all unallowable costs from final indirect cost rate proposals and final statements of costs. Maintain strong accounting controls, identify expressly unallowable and previously disallowed costs, and submit accurate proposals to avoid penalties, interest, and potential disputes.
Contracting Officer
Review the contractor’s proposal for unallowable costs, determine whether any cost is expressly unallowable or previously determined unallowable, assess the correct penalty and interest, consider waiver only under FAR 42.709-6, and issue final decisions when required.
Agency
Apply the statutory and regulatory penalty framework consistently, including the underlying cost principles and any executive agency supplement to the FAR. Support contracting officers with audit, legal, and pricing resources as needed to identify unallowable costs and enforce compliance.
Auditors/Cost Analysts
Examine indirect cost proposals and supporting records to identify unallowable costs, flag expressly unallowable items and repeat inclusions, and provide findings that support the contracting officer’s penalty determination.
Practical Implications
Contractors should treat final indirect cost rate proposals as high-risk submissions and perform a line-by-line unallowable cost review before filing.
The biggest compliance pitfall is not just including an unallowable cost, but including an expressly unallowable cost or one previously found unallowable, which can significantly increase exposure.
Interest can materially increase the penalty amount, so delayed correction or late identification of overpayments can become expensive quickly.
A penalty does not erase the need to repay the underlying unallowable cost if the Government has already paid it, so contractors may face both recovery and penalty exposure.
Contracting officers should document the basis for finding a cost expressly unallowable or previously unallowable, because the penalty determination is a final decision and may be challenged under the Contract Disputes Act.
Official Regulatory Text
As prescribed in 42.709-7 , use the following clause: Penalties for Unallowable Costs (Dec 2022) (a) Definition. Proposal , as used in this clause, means either— (1) A final indirect cost rate proposal submitted by the Contractor after the expiration of its fiscal year which- (i) Relates to any payment made on the basis of billing rates; or (ii) Will be used in negotiating the final contract price; or (2) The final statement of costs incurred and estimated to be incurred under the Incentive Price Revision clause (if applicable), which is used to establish the final contract price. (b) Contractors which include unallowable indirect costs in a proposal may be subject to penalties. The penalties are prescribed in 10 U.S.C. 3748 or 41 U.S.C. chapter 43 , as applicable, which is implemented in Section 42.709 of the Federal Acquisition Regulation (FAR). (c) The Contractor shall not include in any proposal any cost that is unallowable, as defined in subpart 2.1 of the FAR, or an executive agency supplement to the FAR. (d) If the Contracting Officer determines that a cost submitted by the Contractor in its proposal is expressly unallowable under a cost principle in the FAR, or an executive agency supplement to the FAR, that defines the allowability of specific selected costs, the Contractor shall be assessed a penalty equal to– (1) The amount of the disallowed cost allocated to this contract; plus (2) Simple interest, to be computed- (i) On the amount the Contractor was paid (whether as a progress or billing payment) in excess of the amount to which the Contractor was entitled; and (ii) Using the applicable rate effective for each six-month interval prescribed by the Secretary of the Treasury pursuant to Pub.L.92-41 (85 Stat.97). (e) If the Contracting Officer determines that a cost submitted by the Contractor in its proposal includes a cost previously determined to be unallowable for that Contractor, then the Contractor will be assessed a penalty in an amount equal to two times the amount of the disallowed cost allocated to this contract. (f) Determinations under paragraphs (d) and (e) of this clause are final decisions within the meaning of 41 U.S.C. chapter 71, Contract Disputes. (g) Pursuant to the criteria in FAR 42.709-6 , the Contracting Officer may waive the penalties in paragraph (d) or (e) of this clause. (h) Payment by the Contractor of any penalty assessed under this clause does not constitute repayment to the Government of any unallowable cost which has been paid by the Government to the Contractor. (End of clause)