Grant Cost Allocation for Biotech and Deeptech: Direct vs Indirect Explained

The Core Principle: Separating Direct vs. Indirect Grant Costs

That first major grant award feels like a breakthrough. The non-dilutive capital is in, the science is validated, and you have the runway to execute. But that initial excitement quickly meets the reality of federal grant administration. Suddenly, you face a new set of rules about how every dollar is spent, tracked, and reported. Understanding how to separate direct and indirect costs for government grants is not just about compliance; it's a fundamental part of financial management for any R&D-heavy company.

Misclassifying an expense from a direct to an indirect cost is not a simple bookkeeping error. It can trigger reimbursement delays, grantor rejections, and even painful clawbacks that put your startup's cash flow at risk. This guide explains the core principles of cost allocation to help you build an audit-proof system from day one.

The Two Buckets of Grant Costs

At its core, government grant accounting requires you to sort all project-related expenses into two primary buckets: direct costs and indirect costs. Getting this distinction right forms the basis for your entire grant reporting and reimbursement process.

• Direct Costs: These are expenses incurred specifically for the grant project. Think of the lab supplies you buy exclusively for the funded experiment or the salary of the scientist working 100% on that project. These costs are clearly and easily attributable to a single project.
• Indirect Costs (Overhead): These are the shared operational expenses that keep your company running but cannot be tied to a single project. This includes costs like rent for your office and lab space, utilities, or the salary of your administrative staff.

Identifying and Documenting Your Direct Costs

To bill an expense directly to your grant, it is not enough for it to simply be related to the project. The cost must be integral to the project and easily identifiable. Federal guidelines in the United States provide a clear framework for what qualifies as a direct cost. To be charged directly to a grant, an expense must be Allowable, Allocable, and Reasonable.

The Three Tests for Allowable Costs for Grants

Let’s break down these three critical tests. Every direct cost you claim must satisfy all three to be considered compliant.

1. Allowable

An allowable cost is one that is permitted under both the specific terms of your grant award and federal regulations. For US companies, this is governed by the Uniform Guidance (2 CFR 200). Certain types of costs, such as alcohol, entertainment, or lobbying expenses, are almost universally unallowable. Always review your grant agreement carefully for any specific restrictions unique to your award.

2. Allocable

A cost is allocable if it is incurred specifically for the benefit of the grant project. If you buy a piece of equipment used 100% for the awarded work, its full cost is allocable. If it is used 50% for the grant and 50% for another internal project, only 50% of its cost can be allocated to the grant. This principle is why meticulous grant expense tracking, including detailed timesheets for personnel, becomes essential for maintaining compliance.

3. Reasonable

This is often called the “prudent person” test. Would a sensible person, conducting business in a competitive environment, have paid this price for this item or service? This rule prevents the use of grant funds for extravagant expenses. You cannot use grant funds to buy first-class airline tickets for a conference when coach seats are available, nor can you pay a salary that is significantly out of line with market rates for the role and location.

Common Direct Cost Examples for R&D Startups

For most biotech or deeptech startups, typical direct cost examples include:

• Salaries and Wages: Compensation for researchers, engineers, and technicians working directly on the project. This must be supported by timesheets and can include a proportional share of fringe benefits.
• Materials and Supplies: Consumables used exclusively for the grant work, such as lab reagents, cell cultures, specific software licenses, or components for a prototype.
• Equipment: Purchases of machinery or instruments dedicated to the project's scope of work. Note that equipment often has special treatment in indirect cost calculations.
• Subcontracts and Consulting Fees: Payments to third parties for services that are essential to achieving the grant's objectives, such as specialized data analysis or contract manufacturing.
• Project-Specific Travel: Costs for travel necessary to conduct research or present findings at a conference, as long as it adheres to the "Reasonable" test.

How to Calculate and Claim Your Indirect Costs

Your rent, electricity, and administrative support are real costs of doing business, even if they are not for a specific experiment. These are your indirect costs. Grant funders provide a mechanism to reimburse you for a fair share of this overhead through an indirect cost rate. This rate is a percentage applied to your direct costs. For US-based startups, there are two main paths for establishing your indirect cost rates.

Path 1: The De Minimis Rate for Simplicity

For most startups receiving their first federal grant, the simplest path forward is the de minimis rate. This option is designed to reduce the administrative burden on organizations without a history of managing federal funds. "Federal regulations allow organizations that have never had a negotiated indirect cost rate to elect a flat 10% de minimis rate." (2 CFR 200.414). This means you can claim an additional 10% of your modified direct costs as indirect costs, without a complex negotiation process.

However, the calculation is based on a specific figure. "The 10% de minimis rate is applied to Modified Total Direct Costs (MTDC)." MTDC is not your total direct cost base; it excludes certain large expenses. The regulations state that "MTDC excludes specific direct costs, such as equipment purchases and the portion of subcontracts over $25,000."

Here’s a simple calculation example:

• Total Direct Costs: $200,000
• Included in Total: $40,000 for a new piece of lab equipment.
• Included in Total: $35,000 for a subcontract.

1. Calculate MTDC:
   • Start with Total Direct Costs: $200,000
   • Subtract equipment purchase: -$40,000
   • Subtract the portion of the subcontract over $25,000: -$10,000 ($35,000 - $25,000)
   • Your MTDC is $150,000
2. Calculate Indirect Cost Reimbursement:
   • 10% of MTDC = 0.10 * $150,000 = $15,000

In this scenario, your total reimbursement would be $200,000 (Direct) + $15,000 (Indirect) for a total of $215,000.

Path 2: Negotiating a NICRA When the Math No Longer Works

The 10% rate is a great start, but for many R&D-intensive companies, it does not come close to covering actual overhead. This is especially true for biotech and deeptech startups with expensive lab space, shared equipment, and significant administrative support. When your actual overhead rate is much higher than 10%, it is time to pursue a Negotiated Indirect Cost Rate Agreement, or NICRA.

A NICRA is a formally calculated rate negotiated with a cognizant federal agency, often the Department of Health and Human Services (HHS) for NIH grants. The process involves a detailed analysis of your historical costs to determine your actual indirect cost rate. While the administrative burden is significantly higher, requiring robust accounting and a formal proposal, the payoff can be substantial. A scenario we repeatedly see is that "For biotech or deep tech startups with heavy facility overhead, negotiated rates can be 40-60% or higher." A rate that high can dramatically improve your project's financial sustainability and your company's cash flow.

Setting Up Your Grant Expense Tracking System

Effective grant management does not require an enterprise-level accounting system, especially in the early stages. The reality for most pre-seed to Series A startups is more pragmatic: your goal is a “good enough” system built on traceability. An auditor should be able to pick any transaction in your books and easily trace it back to the grant project and the source documentation like an invoice or receipt.

Configuration for US Startups using QuickBooks

For most US startups using QuickBooks Online, this can be achieved with the “Projects” or “Class Tracking” features. Every time you log an expense, from payroll to a vendor payment, you tag it to the specific grant project. This simple act allows you to run a Profit & Loss report by project, instantly showing all direct costs associated with that grant. This disciplined tagging is the foundation of compliant grant expense tracking.

Configuration for UK Startups using Xero

For UK startups, similar functionality exists in Xero using its “Projects” or “Tracking Categories” features. While UK grant bodies like Innovate UK have their own unique grant reporting guidelines and rules for cost allocation methods, the core requirement remains the same. You must be able to isolate and report the costs specific to the funded project. Always refer to the specific guidance for eligible costs provided by your UK funder. The underlying principle of traceability is universal.

The Role of a Formal Cost Allocation Policy

Beyond your accounting software, you should create a simple, one-page Cost Allocation Policy. This internal document formally states how your company defines direct and indirect costs and the methodology you use to allocate shared expenses. It demonstrates to auditors that you have a consistent, logical, and documented process. This simple system, combining software features and basic documentation, is often all that is needed to meet grant compliance requirements.

Key Grant Compliance Requirements and Actionable Steps

Navigating federal grant funding is a learning curve, but establishing a solid framework for cost allocation from day one will prevent major headaches later. The question of how to separate direct and indirect costs for government grants comes down to a few key principles and decisions.

Your immediate action items should be:

1. Formalize Your Cost Definitions: Review the “Allowable, Allocable, and Reasonable” criteria. Write down a simple policy outlining what your startup will classify as a direct versus an indirect cost. This prevents ambiguity and ensures everyone on your team applies the rules consistently.
2. Configure Your Accounting System: Whether you use QuickBooks or Xero, enable project or class tracking immediately. Begin tagging every single grant-related expense to the correct project from the very first day. This is a non-negotiable step for clean and defensible reporting.
3. Choose Your Indirect Cost Rate Path: For your first grant, the 10% de minimis rate is almost always the right choice. It is simple, compliant, and low-risk. However, run a quick calculation. If your rent, utilities, and admin salaries are significantly more than 10% of your R&D costs, start planning for a future NICRA negotiation. This foresight can prevent you from leaving significant money on the table as you scale.
4. Emphasize Documentation: In the world of grant compliance, if it is not documented, it did not happen. Ensure every expense has a clear receipt or invoice and a brief justification for why it was necessary for the project. Inadequate documentation is one of the quickest ways to fail an audit.

By implementing these practical steps, you move from simply managing a grant to strategically leveraging non-dilutive funding to accelerate your research and build a sustainable, audit-proof company. See the Government Grants & Contract Accounting hub for more resources.

Frequently Asked Questions

Q: What is the biggest mistake startups make with grant cost allocation?
A: The most common error is misclassifying costs due to poor tracking. For example, assigning a shared administrative salary as a 100% direct cost to one grant or failing to exclude equipment from the MTDC base for the 10% de minimis calculation. These mistakes can lead to disallowed costs during an audit.

Q: Can I charge my own salary as a direct cost to a grant?
A: Yes, founder and employee salaries can be charged as direct costs, provided the time is spent working directly on the grant's objectives. This must be meticulously documented through timesheets or activity reports that show the percentage of time allocated to the specific grant project versus other company activities.

Q: Is the 10% de minimis rate available for UK grants like those from Innovate UK?
A: No, the 10% de minimis indirect cost rate is a specific provision of the US federal government's Uniform Guidance (2 CFR 200). UK funders like Innovate UK have their own distinct grant reporting guidelines and rules for calculating and claiming overhead, which must be followed for those specific awards.

Q: How detailed does my documentation for grant expense tracking need to be?
A: Your documentation should be sufficient for an independent auditor to understand what was purchased, why it was necessary for the grant, and how the cost was calculated and allocated. This typically means an invoice or receipt, proof of payment, and a note connecting the expense to a specific project task.