IRS Allows Reimbursement of OTC Drugs Under Employer-Sponsored Health Plans

The IRS, in a sudden reversal of its prior position, has ruled that over-the-counter (OTC) medications can be reimbursed under an employer-sponsored health plan without triggering federal income tax on such reimbursements to plan participants. The ruling also allows flexible spending accounts (FSAs) and Health Reimbursement Accounts (HRAs) to reimburse such amounts tax-free. To be reimbursable, the employee must provide the plan with appropriate documentation of the expense. See Rev. Rul. 2003-102, 2003-38 I.R.B. (9/22/03), available at http://www.irs.gov/pub/irs-drop/rr-03-102.pdf.

The change constitutes good news for health plans and employers, which have been struggling to control rapidly escalating prescription drug costs. Plans may now, for example, be able to require that a participant first try a cheaper, but covered, OTC medication and only provide coverage for a prescription alternative if the OTC drug proves ineffective or has a contraindication. The most significant area of immediate potential savings for plans will be in the area of non-sedating antihistamines, where Claritin and similar drugs recently have become available over the counter. Other rugs are increasingly becoming available without prescription.

Before this ruling, many health plans had been forced to discontinue reimbursement for medications as they became available over the counter. While an OTC drug is less expensive than the prescription drug, the cost to many consumers can increased because the price paid for the OTC drug exceeded the co-payment that applied when the drug was covered by insurance. This can be a significant an issue for individuals who remedy chronic health problems by regularly taking an over-the-counter medicine.

The new ruling explains that the statutory exclusion for reimbursements of employee medical expenses under Section 105(b) of the Internal Revenue Code ("Code") is broader than the itemized deduction for medical expenses under Code Section 213 (which does not allow taxpayers to deduct the expense of nonprescription drugs). Thus, despite the fact that an individual cannot deduct payments for OTC drugs as a medical expense if he or she paid it personally, the individual will be able to exclude from income any amounts reimbursed for such medications under an employer-sponsored health plan.

Many employers, HMOs and insurers will wish to amend their health plan documents to permit coverage for the cost of certain OTC medications. There are, however, many different ways to structure such an amendment so as to produce maximum cost savings to a particular plan. If you are interested in discussing how your health plan benefits and plan documents could be modified to reflect the new rules on OTC drugs, please contact your regular Crowell & Moring contact or any attorney on our Health Care team.