Pure Defined Contribution - A Health Insurance Allowance

Written by: Christina Merhar
Originally published on October 22, 2013. Last updated October 26, 2020.

Pure defined contribution health models are fast becoming popular with small businesses. With pure defined contribution a business contributes a fixed dollar amount (a "defined contribution") toward employees' health insurance costs.

A simple way to think about it is providing a health insurance allowance to employees.

health insurance allowance

Overview of Health Insurance Allowances

With a pure defined contribution model, businesses provide a health insurance allowance to employees to spend on qualified personal health insurance policies. 

With this approach, a business would follow these four steps:

  1. Not offer a traditional employer-sponsored health insurance plan.

  2. Use defined contribution software to give each employee a fixed health insurance allowance.

  3. Assign a health insurance broker to help employees enroll in individual health insurance through the marketplace, and receive a discount via a health insurance subsidy (if eligible). Employees can also enroll in health insurance "off" the marketplace through a broker, online, or a private exchange.

  4. Reimburse employees on payroll, after employees submit proof of their health insurance to their defined contribution software provider.

The defined contribution plan (and health insurance allowance) is not a health insurance plan. Rather, it's a compliant way to reimburse employees for individual health insurance premiums.

How the Health Insurance Allowance is Set Up

The most common approach to providing a health insurance allowance is to use a limited-purpose Section 105 medical reimbursement plan. With this type of plan, the business decides:

  • The amount of the health insurance allowances 

  • Who is covered (employee and dependents, or just employee) 

  • Employee eligibility criteria (hours worked, waiting period, etc.)

By using a Section 105 medical reimbursement plan, the employer stays compliant with ACA, IRS, ERISA, and HIPAA regulations. In fact, a Section 105 plan is one of the only compliant ways a business can provide reimbursement for personal health insurance policies. Likewise, to ensure compliance and easy administration, nearly all businesses use a defined contribution software provider to set up and administer the health insurance allowance. 

Trend Toward Health Insurance Allowances

For small businesses, recruiting and retaining quality employees is vital. Offering health benefits is an important part of the compensation offered to them, and it sets the business apart as an employer of choice.

Whether the business is hiring its first W2 employee, a formal health benefits package is needed to retain a key employee, or group health insurance costs exceed internal budgets, providing a health insurance allowance allows small businesses to offer formal health benefits.

Another reason many small businesses are using health insurance allowances is because of new opportunities with health reform.

  • Massive tax subsidies on the individual insurance market will be available to most employees (eligibility is based on household income).

  • All individual policies are guaranteed-issue, eliminating the non-economic (i.e. moral) factors from a small business's decision-making process. In other words, businesses feel assured that sick employees will be able to secure individual health coverage.

  • For small businesses (fewer than 50 employees) there is no employer mandate and no penalties for not offering traditional health insurance in 2015.

Questions about how to provide a health insurance allowance to employees? Leave a comment below.

The Comprehensive Guide to the Small Business HRA 

Originally published on October 22, 2013. Last updated October 26, 2020.


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