You Spent the Money, Now Prove It Was Allowed

HiQuity Solutions
Apr 24
5 min read

Updated: 6 days ago

POST 5 of 10

Series - Grant Ready: A Compliance Readiness Framework for Federal Award Recipients

Introduction

Budget development is where the real compliance work of a federal grant proposal begins. Every line item your organization includes in an application is a commitment not only to the funder reviewing the proposal, but also to the regulatory framework that governs how every dollar of that award can be spent once it arrives.

Most organizations approach the budget as a math exercise, but federal auditors approach it as an accountability document, so the takeaway to keep in mind here is that what you build into the budget now determines what you can defend later, and what you may be required to repay.

HHS Grantee Note: The regulatory citations throughout this series reflect 2 CFR Part 200, which fully replaced 45 CFR Part 75 as the governing framework for HHS awards effective October 1, 2025. If your organization's compliance policies still reference Part 75, see Post 1 of this series for what changed and what your organization needs to do.

The Three-Part Test Every Cost Must Pass

Under 2 CFR § 200.403, costs charged to a federal award must meet all of the following criteria to be considered allowable. Failing any one of them is sufficient for a cost to be disallowed, meaning the organization will repay that amount from non-federal funds, often with interest.

Necessary and reasonable: A cost is reasonable if it does not exceed what a prudent person would incur under the same circumstances at the time the decision was made. The standard isn't whether the cost benefited the program or whether leadership approved it internally, but whether a neutral observer, an auditor applying the prudent person standard, would consider the expenditure appropriate given the nature of the award and the documented need for the item.
Allocable: A cost is allocable to a federal award if it is incurred specifically for that award, benefits both the award and other work and can be distributed proportionately, or if it is necessary to the overall operation of the organization and can be assigned in part to the award on a reasonable, documented basis. A cost charged to a federal grant simply because funding is available rather than because the cost directly serves the award's purposes is not allocable, regardless of how reasonable it might otherwise appear.
Consistent treatment: Costs must be treated consistently across all of an organization's activities. A cost that is charged as a direct cost on one federal award cannot be treated as an indirect cost on another award for the same type of expenditure, and vice versa. Inconsistent treatment will be one of the more technically complex compliance failures organizations encounter, particularly when managing multiple awards simultaneously.

All three criteria must be satisfied, meeting one or two out of three will be a disallowance.

Costs the Regulations Explicitly Prohibit

Beyond the three-part test, 2 CFR Subpart E identifies specific cost categories that are unallowable under federal awards regardless of whether they appear reasonable or beneficial to the program. These are worth knowing during budget development because they represent costs organizations sometimes include in proposals without realizing they are prohibited.

Alcoholic beverages: Unallowable under all circumstances, with no exceptions.
Entertainment costs: Costs of amusements, social activities, and related incidentals, including meals associated with those activities, are unallowable unless specifically authorized by the federal award.
Lobbying costs: Costs associated with influencing legislation, elections, or regulatory rule-making at any level of government are unallowable under federal awards.
Fundraising costs: Costs of organized fundraising — including financial campaigns, endowment drives, solicitation of gifts and bequests, and similar activities — are unallowable as charges to a federal award.
Profit: Recipients and subrecipients executing federal awards or subawards may not charge an increment above cost as profit. Federal awards are cost-reimbursement instruments; they cover allowable costs, not margins.
Certain executive compensation: Compensation for senior organizational leaders charged to federal awards is subject to reasonableness standards and in some cases statutory caps, particularly for awards from agencies with specific limitations on executive pay.

Where Budget Mistakes Get Locked In

The budget narrative submitted with a federal proposal becomes part of the approved award once funding is made. Costs that are built incorrectly into the approved budget do not become allowable simply because a federal agency approved the award. The agency's approval of a budget reflects acceptance of the cost structure as proposed, not a determination that every line item meets the regulatory test.

This means two types of errors are particularly costly:

Costs included without adequate justification: If a budget line item cannot be tied to a specific program purpose, the award period, and the documented need for the expenditure, it may not survive post-award scrutiny even if it was approved at the proposal stage. Documentation of cost necessity and reasonableness is an ongoing obligation — not something that ends at award.
Costs charged to the wrong award: Organizations managing multiple federal awards sometimes shift costs between awards to manage cash flow or address budget shortfalls in one program. Under 2 CFR § 200.405(c), a cost allocable to a particular federal award may not be charged to other federal awards to overcome fund deficiencies or avoid restrictions imposed by the terms of the award. This is one of the audit findings that most frequently results in significant repayment demands.

Prior Approval: When You Need It Before You Spend

Certain cost categories require prior written approval from the federal awarding agency before they can be incurred and charged to the award, even if they appear in the approved budget. Under 2 CFR § 200.407, these include items such as pre-award costs, costs for rearrangements or alterations of facilities, and certain participant support costs, among others.

Organizations that incur these costs without prior approval, assuming that an approved budget line is sufficient authorization, risk having those costs disallowed upon audit. The approved budget and prior written approval are separate requirements, and both may be necessary for the same cost.

Why This Matters During Proposal Development

Every cost in a federal budget narrative should be buildable from the bottom up and tied to a specific activity, a documented need, a reasonable market rate, and a clear connection to the award's programmatic goals. Organizations that build budgets this way during the proposal stage are the ones that can defend every line item when a monitoring visit or audit asks them to.

The three-part test is not an audit tool, but a budget-building tool that happens to be enforced by auditors. Applied during proposal development, it filters out the costs that will create problems later and forces the kind of documentation discipline that makes post-award management significantly more manageable.

Building a federal budget and want to know whether your cost structure will hold up under audit scrutiny? HiQuity Solutions works with organizations during the proposal stage to build budgets that are defensible from day one.

Get Help with a Defensible Budget

References

[1] 2 C.F.R. § 200.403. Factors Affecting Allowability of Costs. OMB Uniform Guidance, as revised October 1, 2024. https://www.ecfr.gov/current/title-2/part-200/subpart-E

[2] 2 C.F.R. § 200.404. Reasonable Costs. OMB Uniform Guidance, as revised October 1, 2024. https://www.ecfr.gov/current/title-2/part-200/subpart-E

[3] 2 C.F.R. § 200.405. Allocable Costs. OMB Uniform Guidance, as revised October 1, 2024. https://www.ecfr.gov/current/title-2/part-200/subpart-E

[4] 2 C.F.R. §§ 200.420–200.475. Selected Items of Cost. OMB Uniform Guidance, as revised October 1, 2024. https://www.ecfr.gov/current/title-2/part-200/subpart-E

[5] U.S. Department of Labor. 2 CFR 200 Frequently Asked Questions, Question 38 (January 15, 2025). https://www.dol.gov/sites/dolgov/files/OASAM/legacy/files/20250115-2CFRPart200FAQs.pdf

[6] 2 C.F.R. § 200.407. Prior Written Approval. OMB Uniform Guidance, as revised October 1, 2024. https://www.ecfr.gov/current/title-2/part-200/subpart-E