FSL03:

Simplify Reimbursement Procedures for Administrative Costs of Federal Grant Disbursement

Background

Approximately $19 billion of federal grant funds is used to reimburse states and localities for administrative costs. Administrative costs include:

--the federal portion of expenses states incur to administer public assistance programs such as Aid to Families with Dependent Children (AFDC), Medicaid, and Food Stamps;

--the direct and indirect administrative expenses associated with federal formula and block grants; and

--the indirect costs of the various state departments that administer federal discretionary grants.

State and local governments account for administrative costs under a system established 25 years ago through OMB Circular A-87, "Cost Principles for State and Local Governments," which sets forth principles, standards, and processes for determining charges to federal grants.

Because states and localities incur costs that benefit both the particular jurisdiction and a wide variety of separate federal programs, a complex allocation process is used to determine the equitable distribution of these common costs between the states and federal government, and across multiple federal grant programs.

OMB Circular A-87 requires states to develop a cost allocation plan that must be reviewed and approved by the federal Department of Health and Human Services (HHS), to determine:

--the dollar amount of central services (e.g., purchasing, personnel management, and financial management) to be allocated to the various state departments; and

--the methodology for determining the amount of charges for central services that are funded on a billed or fee-for-service basis.

In addition, state agencies administering federal public assistance funds must receive prior HHS approval of plans for allocating administrative costs among the various programs that they administer.

A number of large local governments must also receive advance approval of cost allocation plans. Other local governments receiving federal assistance are required to develop cost allocation plans and indirect cost proposals, and retain them for audit. Also, each state agency receiving federal funds negotiates an indirect cost rate with the federal department from which it receives the largest amount of funds.

Need for Change

Concerns regarding the effectiveness of the system in controlling costs, as well as the accounting and allocation burdens the current system imposes, have been documented in the General Accounting Office (GAO) and HHS audit reports and expressed by federal, state, and local officials in interviews.

Since 1980, administrative costs have often grown disproportionately compared to the growth in programs. Faced with their own fiscal pressures, many states and localities have explicitly pursued policies for administrative cost maximization, sometimes using consultants and firms specializing in federal cost reimbursement maximization strategies.

A healthy debate exists about these strategies--with states and localities arguing that they are simply claiming their fair share after years of unintentional underreporting, and federal managers asserting that this is simply gaming the system. Either way, there is little question that uncontrolled growth in administrative costs could continue indefinitely in the face of severe federal deficit constraints.

The HHS inspector general has also concluded that not enough is being done at federal and state levels to ensure that only allowable costs are being paid. The inspector general estimates that hundreds of millions of dollars in reimbursements have been paid historically for costs that would be disallowed if the federal government had the time or resources to conduct exhaustive and detailed audits. However, in the past several years, the staff resources available in HHS to audit as well as to review and approve cost allocation plans and negotiate indirect cost rates has decreased significantly, further diminishing the federal capacity to oversee the system.

An HHS audit report states that the system for accounting for administrative costs has ". . . grown arcane and has slowly degenerated into a highly technical accounting and allocation maze."[Endnote 1] Clearly, the existing system is overly burdensome for both state and local governments. For example:

--Huge disparities exist among and between jurisdictions.[Endnote 2]

--States are often required to negotiate indirect cost rates with as many as 14 separate federal agencies.

--Thousands of cost allocation plans are prepared annually for no purpose other than satisfaction of OMB Circular A-87 requirements

--Significant costs are incurred at the state and local levels to administer the costing methods such as random moment time studies required by the plans.

Various approaches to changing the system have been considered by members of Congress, OMB, HHS, the Congressional Budget Office, the National Association of State Budget Officers, and the National Governors' Association, among others. In the past, no single proposal has had sufficient support for adoption. Nevertheless, there remains broad consensus that change is badly needed.

Action

Modify OMB Circular A-87 to provide a fee-for-service option in lieu of cost reimbursement. (2)

OMB should modify Circular A-87 to give states and localities the option of electing a fixed fee for service in lieu of the current method of administrative and overhead cost reimbursement.

This approach would fix the rate of administrative costs for individual states and localities based on each jurisdiction's experience, but allow total fees paid to increase or decrease in proportion to program expansion and contraction. The measure to which administrative costs are most sensitive (e.g., the number of clients, number of payments, program costs expended) would be determined for individual programs.

The actual administrative costs would be ascertained for individual states and localities for a base period, and expressed as a percentage or unit cost of the measure identified.[Endnote 3] Administrative fees would be paid in the form of a lump sum from each program by applying this percentage or dollar amount to the selected program measure for each year. [Endnote 4] Although states or localities would have to absorb any deficits in relation to actual costs, they would retain any savings that they could develop through efficient management practices. This would maximize incentives for cost containment and efficiency and provide an opportunity for gainsharing by more efficient jurisdictions.

An administrative fixed fee system reduces expenses by eliminating costly preparation and submission of allocation plans and indirect cost proposals, as well as by eliminating the applicability of federal requirements for maintaining cost records and reporting, and federal audits of administrative costs. Further, the fixed fee approach ensures that future changes in administrative funding are proportionate to program growth, increasing the predictability of federal costs and concentrating precious resources on service delivery. The system would also provide new incentives for cost efficiencies in states and localities.

We estimate half the governments will elect the fee for service option, leading to federal savings of $3.3 billion over five years.

Endnotes

1. See U.S. Department of Health and Human Services, Office of Inspector General, Reforming the System for Determination of State and Local Government Administrative/Indirect Costs (Washington, D.C., September 3, 1993).

2. For example, in fiscal year 1991, Alaska spent $300 per recipient to administer AFDC, Medicaid, and Food Stamps, while West Virginia spent only $54.

3. Base period levels would have to be adjusted for one-time nonrecurring costs (such as major information system development) that would otherwise skew or misrepresent the true, ongoing administrative burden.

4. Fee adjustments would be used to take into account inflation and program changes.