Most government contractors do not have issues with audits because executives are overpaid — they have issues because they cannot prove their pay is reasonable.

If you deliver work under federal contracts, understanding how the government evaluates executive compensation is a core compliance requirement – one that directly affects what you can bill, what gets disallowed, and how you fare under audit.

And yet, many contractors approach executive compensation with the wrong assumptions or incomplete frameworks. Common missteps include relying on the statutory cap as a proxy for compliance, treating benchmarking as optional, or failing to document how compensation decisions were made in the first place. Others blur the line between allowable and unallowable costs or assume that scrutiny applies only to C-suite roles. 

In this article, we cut through the confusion, clarifying what “reasonable” actually means in a government contracting context and where contractors most often go wrong.

Reasonableness vs. allowability — They are not the same

One of the most common breakdowns in executive compensation compliance starts with a misunderstanding of what is actually being tested.

Contractors often approach compensation through a single lens – often the statutory cap – because it feels clear, measurable, and easy to track. If compensation falls within that limit, organizations assume they are compliant. But that mindset oversimplifies how the government evaluates costs.

In reality, executive compensation is primarily evaluated through two distinct FAR-based criteria that operate independently.  

• Allowability is about the statutory compensation cap (referenced at FAR 31.205-6(p)), which is how much of an executive’s pay can be charged to federal contracts. 
• Reasonableness is about whether the pay itself is appropriate for the work performed, based on market data and business circumstances. Regulatory requirements for labor cost reasonableness are laid out at FAR 31.205-6(b).  

Each has its own purpose, its own criteria, and its own implications for audit risk and cost recovery. Allowability affects cost recovery. Reasonableness affects whether your costs are defensible at all. 

Focusing on one while overlooking the other creates gaps that auditors are quick to identify. You can pass one test and fail the other. You can even have reasonable compensation that is not allowable above the cap. 

Understanding this distinction is the first step toward compliance.

The statutory cap: what it is — and what it is not

The statutory cap is one of the most misunderstood rules in government contracting.

Here’s the simple version:

• It limits what you can bill to the government. 
• It does not determine whether compensation is reasonable. 
• Compensation for all employees in excess of the statutory limitation is unallowable. 
• Anything above the cap must be recorded and allocated to the proper unallowable accounts. 

Most contractors do not get in trouble for exceeding the cap. They get in trouble when they cannot clearly track, segregate, and support how excess compensation was treated, leading to questioned or disallowed costs.

Highly compensated employees are usually executives — but not always

When contractors hear “highly compensated employees,” they often assume it refers strictly to top executives. In practice, while executives typically make up the majority of this group, they are not the only employees who may fall into this category. 

Highly compensated employees can include: 

• Senior technical experts or subject matter specialists 
• Business development leaders tied to revenue generation 
• Key personnel in niche or high-demand labor categories 

From a compliance standpoint, this matters for two reasons: 

• Reasonableness must be evaluated based on the role, not just the title. A highly paid engineer or scientist may be reasonable if their compensation aligns with market demand and contract needs, even if they are not in an executive position. However, without clear justification, that same compensation can quickly become a focal point in an audit. 
• Contractors must apply a consistent methodology across all highly compensated employees. Selectively documenting executive pay while taking a lighter approach elsewhere creates gaps in your support. In an audit, inconsistency raises questions about your overall compensation framework, not just individual decisions. 
• Executives often draw the most scrutiny in an audit, but high compensation must always be justified, regardless of the job title.

Why contractors get caught off guard

These issues all point to the same underlying problem: the absence of a clear methodology for formally supporting compensation decisions.

Common pitfalls include: 

• No benchmarking or market data 
• Vague or outdated job descriptions 
• No written rationale for pay decisions 
• Blending allowable and unallowable compensation 
• Missing board minutes or compensation committee notes 

Reasonableness is ultimately about showing your work. If you can demonstrate how you arrived at compensation decisions and why they are/were reasonable, you are already ahead of most of your peers. 

Bottom line 

Executive compensation does not have to be complicated, but it does have to be defensible to avoid surprises during an audit. Understanding the rules, documenting your decisions, and keeping your structure clear will put you in a strong position when auditors come calling.

Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.