IRS Guidance on FSA and HSA Reimbursements for OTC Drugs

By Elizabeth Buchbinder, J.D., Washington, DC

Editor: Michael Dell, CPA

Gross Income

The IRS has issued guidance (Notice 2010-59 and Rev. Rul. 2010-23) implementing the Patient Protection and Affordable Care Act’s prohibition on reimbursement of the cost of over-the-counter (OTC) drugs by health savings accounts (HSAs), health reimbursement accounts (HRAs), Archer medical savings accounts (MSAs), and flexible spending accounts (FSAs). The prohibition, which is effective January 1, 2011, allows reimbursement for an OTC drug only if the individual has a prescription for the drug.


Current law permits various individual health account arrangements to reimburse for moneys spent on OTC drugs such as aspirin as well as prescription drugs. The rules governing such reimbursements are specified in Rev. Rul. 2003-102. The Patient Protection and Affordable Care Act, P.L. 111-148 (PPACA), prohibits FSAs and HSAs from reimbursing a participant for the purchase of OTC drugs unless the participant has a prescription for the OTC drug (even though a prescription is not needed to obtain the drug).

Some FSAs and HRAs provide participants with health debit cards to use for the purchase of covered medical items. The rules for the use of debit cards are set forth in Prop. Regs. Sec. 1.125-6, Rev. Rul. 2003-43, and Notices 2006-69, 2007-2, and 2008-104. These rules allow the use of health debit cards at merchants that have an inventory information approval system or at a pharmacy where 90% of the store’s gross receipts during the prior tax year consist of items that qualify as medical expenses under Sec. 213(d).

New Guidance

The IRS issued Rev. Rul. 2010-23, which makes Rev. Rul. 2003-102 obsolete, to explain how the new restrictions will apply beginning on January 1, 2011. Under the PPACA change, the Code will allow tax-free reimbursement only if the drug (1) requires a prescription, (2) does not require a prescription but the individual has a prescription for it, or (3) is insulin. Amounts distributed to FSA or HSA participants for purchases that do not satisfy one of these requirements will be includible in the participants’ gross income and are generally subject to an additional 20% tax.

Notice 2010-59 defines a prescription as a written or electronic order for a medicine or drug that meets the legal requirements of a prescription in the state where the expense is incurred and is issued by a legally authorized individual. The prescription rule does not apply to equipment such as crutches, supplies such as bandages, and diagnostic devices such as blood sugar test kits. These items may qualify under the definition of medical care in Sec. 213(d)(1), which includes expenses “for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.”

Because current health FSA and HRA debit card systems are not capable of recognizing and substantiating that medicines and drugs were prescribed and thus cannot ensure compliance with the new law, Notice 2010-59 limits the use of debit cards in the purchase of OTC drugs on and after January 1, 2011. However, the notice provides that, notwithstanding that restriction, the IRS will not challenge an individual’s use of a debit card to purchase OTC drugs before January 16, 2011 (assuming the purchase complies with prior rules).

After January 15, 2011, individuals may continue to use debit cards for OTC drug purchases (with a prescription) in a pharmacy that satisfies the 90% test; however, the purchaser must then submit substantiation (including the prescription) to the independent third party authorizing the purchase. Sales of OTC medicines and drugs at the pharmacy may continue to be taken into account after December 31, 2010, for purposes of the 90% test. For OTC drug purchases from a seller other than a pharmacy satisfying the 90% test, the individual must pay for the purchase (not using the health debit card) and then provide substantiation to get reimbursed. The notice offers an example of the type of substantiation required: a customer receipt that identifies the person the prescription is for, the date and amount of the purchase, and a prescription number or copy of the prescription.

Observation: These debit card rules affect only OTC drug purchases, whether or not the purchases are made at pharmacies meeting the 90% test. Individuals may still use debit cards for drugs that require a prescription and for other reimbursable medical expenses such as insulin, medical equipment or supplies such as crutches or bandages, and diagnostic devices such as diabetes testing kits.

Notice 2010-59 is effective for expenses incurred after December 31, 2010, regardless of whether the plan year for the employer’s plan is a fiscal-year or calendar-year plan or whether there is no plan year, and regardless of any otherwise applicable grace period for an FSA. Purchases made before December 31, 2010, but submitted for reimbursement after that date are not limited by the new law. If a cafeteria plan must be amended to conform to the new OTC drug requirements, the amendment may be made retroactively to expenses incurred after December 31, 2010, if the amendment is made no later than June 30, 2011.


The new rules are likely to create considerable confusion for all involved. Because the rules apply only to OTC drugs (not medical supplies or prescription drugs), employees and customers may have difficulty distinguishing what the rules do and do not apply to, especially where codes need to be reprogrammed in a computer inventory system. Customers are also likely to be confused about what they can use their debit cards for and what kind of paper substantiation they will now need to submit. Retailers of OTC medicines and drugs will no doubt find it important to educate their employees and customers about the new rules.


Michael Dell is a partner at Ernst & Young LLP in Washington, DC.

For additional information about these items, contact Mr. Dell at 202-327-8788 or

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