The Defense Appropriations Acts for 2008, 2009, and 2010 contained provisions that limited payments of indirect costs to just 35 percent of total cost of a contract, grant, or cooperative agreement for "basic research". Basic research in this case means funds in programs withing DoD's Budget Activity 1 of the Research, Development, Test and Evaluation appropriations. If you are uncertain whether any of your DoD awards include basic research funds, you should clarify such before the contract auditors arrive. They were recently instructed to verify whether contractors are complying with these provisions during their audits of incurred costs. Interestingly, the DoD Appropriations Acts of 2011, 2012, and 2013 did not carry forward these limitations.
The limitation of payments apply only to prime contractors. The restriction does not flow to to subcontractors or other subordinate instruments.
For the restriction on payment of indirect cost as a percentage of total cost, "total cost" has the meaning given in the Federal cost principles that apply to the particular awardee. For "for-profit" contractors, this would be the cost principles in FAR Part 31. "Indirect costs" are those defined in FAR 31.203, Indirect Costs. Non-profits will want to refer to 2 CFR part 220, 225, or 230, as appropriate.
During an audit, contractors may be requested to demonstrate their internal procedures for compliance with this limitation.
Sometimes, federal awards are incrementally funded. This may entail the use of funds subject to the restriction and funds that are not subject to the restriction. This will require additional accounting complexities to ensure that the system can account for restricted and non-restricted funds.
If your indirect costs do not exceed 35 percent of total direct costs, this restriction becomes moot and contractors can document such and move on. For most recipients of basic research funds, indirect costs will exceed the 35 percent threshold and care will need to be exercised to ensure that the Government is not overbilled.