The Ruling

The Ruling holds that a health plan can reimburse an employee for medicine and drugs obtained without a physician's prescription. The basis for the Ruling is Section 105(b) of the Internal Revenue Code (IRC), which allows the exclusion of reimbursements for medical expenses paid by group health plans (including medical plans, flexible spending arrangements (FSAs), and health reimbursement arrangements (HRAs)).

The Ruling permitted an FSA to reimburse an employee for medicine and drugs purchased without a prescription (including antacids, pain relievers, allergy medications and cold medicine) because they are expenditures for medical care.

According to the Ruling, expenses for dietary supplements (e.g., vitamins) and other items that are not for medical care are still not reimbursable because they are merely beneficial to the employee's general health. The IRS stated that OTC drugs are still not deductible by employees in their individual tax return under IRC Section 213.

Although the Ruling broadens the scope of allowable expenses, it does not change the substantiation requirements, which mandate that plan administrators receive proof that what the individual bought was eligible for reimbursement, before paying the benefit.

The implications for plan sponsors are significant.

Implications for Sponsors of FSAs and HRAs

Clearly, this ruling will make FSAs and HRAs more attractive to some participants and could increase participation rates for plans that offer these accounts to workers.

Plan sponsors that maintain an FSA or HRA would generally have to amend their plan documents in order to permit payment of OTC drugs and remove any exclusion prohibiting such payment. However, if an FSA or HRA has a broad definition of reimbursable expenses it might be automatically required to pay for OTC drugs under this ruling. For example, if the plan document defines reimbursable expenses as medical expenses under IRC Section 105, then, based on this new interpretation of IRC Section 105, it would have to pay for OTC drugs. If, however, the plan excludes OTC drugs, as many do, or if it refers to IRC Section 213 to define reimbursable expenses, an amendment would be required to take advantage of this ruling. Plan sponsors will have to rely on legal counsel to carefully review both the definition of reimbursable expenses and the existing exclusions when implementing this Ruling.

When designing the OTC coverage levels, plan sponsors should take into account the following considerations:

• What OTC drugs will the plan cover: The Ruling specifically permits coverage of antacids, allergy medicine, pain relievers and cold medicine. Should the plan sponsor use this list or attempt to refine the payment structure more carefully?
• What limits on OTC coverage will be imposed? Should a maximum amount for OTC be included in the plan?
• What substantiation requirements will be necessary? For example, receipts should show name of item, date of purchase, and price. Plan administrators will need to consider how to determine who bought the drug and for what purpose. Plan administrators who do not carefully design the OTC benefit could be faced with a flood of receipts from drug and grocery stores for hundreds of different OTC medicines and drugs.
• Will coverage be permitted for 2003 or only during future plan years? Under the Revenue Ruling, the benefit can be effective for as early as the current year, if the plan sponsor chooses.

Implications for Sponsors of Plans that Cover Prescription Drugs

Although the Ruling specifically applies to health FSAs and HRAs, the principles are applicable to other employer-sponsored benefit plans that provide pre-tax health care benefits, such as an insured or self-insured group health plan.

Furthermore, because OTC medications can serve as low-cost alternatives to prescription drugs for many participants, plan sponsors should consider if the new ruling could serve as an opportunity to reduce plan costs. For example, a plan sponsor may be able to cover OTC drugs on a limited basis (e.g., certain allergy medications or antacids). Coverage would have to be carefully constructed so that OTC drugs would replace equivalent prescription drug therapies at a lower cost to both plan sponsor and participant. In addition, any OTC use can be integrated with the clinical drug utilization review edits currently administered by the pharmacy benefit manager (PBM). Plan sponsors may wish to consult with its prescription drug benefit consultants or PBMs to determine whether a more extensive program of reimbursing OTC drugs would be workable.

For assistance in determining whether and how to modify coverage for OTC drugs in response to the new Revenue Ruling 2003-102, including conducting a cost-benefit analysis before making plan design changes or renegotiating contracts with PBMs, contact your Segal consultant or the nearest Segal office.