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Out Of Pocket Expense

Updated on July 2, 2024
Article byWallstreetmojo Team
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

Out Of Pocket Expense Meaning

Out-of-pocket expense refers to the direct payment generally made in the form of cash by one which in the future may or may not be borne by an external third party as it does not fall under their liabilities. In business, it can be the employee’s spending which one has spent for business- or work-related purposes.

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The employees, first spend the money out of their pocket, and then these get reimbursed by the company or business. Such expenses are often associated with medical insurance, which does not come under reimbursable once. Some of them may be deducted from the income tax provided they add up to an amount that will be more than the standard deduction.

Out Of Pocket Expense Explained

The out of pocket expenses refer to the amount that an individual has to spend from their own resources and which may or may not be compensated from any source, like a third party or an employer. Individuals often handle various types of expenses during their day-to-day life which do not come under the purview of getting compensated, like expenses related to the parking or toll payment of a personal vehicle, charity contributions, fees for education, and so on.

Such out of pocket expenses insurance are made from one’s own resources and very often they result in quite a substantial cash outflow from their personal resource. Some organizations take the initiative to reimburse some of them up to a limit, but more often they are personal expense.

Out-of-pocket pockets range for a varied number of things. It may or may not be reimbursed by the third party, which depends on a case-to-case basis. Usually, for businesses or companies, when employees pay from their pocket the business-related or work-related expenses, it gets easily reimbursed. In contrast, for medical insurance, there are certain payments like prescription fees, which the customer initially has to pay out of their pocket. Still, later these cannot be reimbursed, too, since it’s now under the clause of the medical insurance policy. It can also refer to cash, which is spent on deductibles and co-pays.

Such out of pocket expenses insurance or cash pay out can also be related to real estate, while purchasing a property. During the sale procedure, the buyer has to pay some amount from their own pocket, which are not related to mortgage payment. They maybe the payment made at regular intervals to an escrow account, cost of inspection or home renovation, any appraisal fees, fees to the attorney, tax on property etc.

What Are Health Insurance Out-Of-Pocket Expenses?

Health insurance out-of-pocket expenses are the expenses that are not covered by the medical policy or the health insurer, and these costs need to be borne by the policyholder only. These can be various charges, such as prescription fees, deductibles, co-payments, and coinsurance. There are also certain expenses like ambulance charges, gloves, and other items not covered under the medical insurance policy. Thus, the policyholder must straightaway pay these sorts of expenses from their pocket, and the insurance company covers the rest.

Here, along with out of pocket expenses clause, we can elaborate a bit on the concept of copayment, where a certain percentage of the claim amount is to be paid by the insured for each and every claim. This makes it different from the deductible concept, in which a fixed amount is paid by the insured, irrespective of the claim amount. The percentage amount that will be a copay, is typically mentioned in the insurance policy and it should be paid before the claim is received.

The system of copay is activated when the claim is made. As soon as it is done, the insurer will ask the insured to make the copayment first and the insurer will pay the rest of the claim. However, the insured should understand that it is quite profitable to go for a policy that offers copayment system because such an out of pocket expenses clause reduces the premium which is a monthly or yearly payment that the insured has to pay even though there is no claim. The larger the copayment amount, the lower will be the premium amount.

From the point of view of the insurance company also, it is a great option because the insured will avoid claiming for small reasons because they have to pay some amount from their own pockets. The insurance company can save on their funds and avoid the hassle of documentation and paperwork very frequently. It also discourages hospital admissions, especially the expensive ones, for small reasons that can be treated at home with medication.

But here, another crucial point to understand that if the copayment is high, it will definitely lower the premium, but the basic reason of insurance will take a backseat. It reduces the importance of insurance and curbs its usefulness. Financial aid during necessity related to health issues is an important requirement for the citizens of any country.  Thus, here we notice the fact that the money saved from low premiums is shelled out by paying for copayment, which is not much useful.

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Examples

Let us understand the concept of out of pocket expenses audit and claim with the help of some suitable examples as given below.

Let us assume the case of medical insurance, where we have deductibles, co-pays/co-insurance, and out-of-pocket costs attached to the overall medical policy.

 Let us assume we have a medical insurance policy with a maximum limit of $60,000. The person holding the policy has incurred a medical expense of $40,000. According to the medical policy, one may think the insurance company should bear the entire expense, but that is not the case. It is where the out-of-pocket expense concept comes in. In this case, the insurance policy states that it has a $2,000 deductible and 20% co-insurance, and a maximum of $8,000 the pocket expense.

Thus, when the policyholder has incurred a bill of $40,000 first, the deductible of $2,000 straightaway must be borne by him. Next comes the co-insurance part, where 20% of the cost, so for the first $30,000 bill, the 20% charges come to be $6,000. Thus, adding the deductible and co-pay, which is $2,000+$6,000 = $8,000, we find the maximum out-of-pocket expense bracket has been reached, which was earlier stated as $8,000. Thus, the insurance company, out of the entire $40,000 bill, bears only $32,000, and the rest of $8,000 is borne by the policyholder.

In this context, it is also important that we have some knowledge about the impact of this system in our tax returns that we file at the end of the year. There are some such expenses that may be deducted from the income tax. For instance, if an individual makes some donations to the charity, then such a donation amount is subject to tax deduction, which will lower the tax amount and tax burden for the year, that they have to pay, thus saving some money.

Some companies have the policy of out of pocket expenses audit and therefore, sometimes pay or reimburse those expenses made by an employee due to relocation to another place. But mostly, such moving expenses are not compensated, except for person working in military and has to shift due to orders related to their job. But since they are paid by the government, they cannot be claimed as any deduction from tax.

Advantages

There are several benefits of of out of pocket expenses in accounting, which are as follows:

  • Such expenses can be used under tax deductions like charitable donations, a medical expense that has not been reimbursed, etc. It can help in reducing the tax burden.
  • In medical insurance, the co-insurance part generally plays the role of a commitment of the policyholder towards the insurance. Generally, this is seen as collateral or down against the policy taken.
  • Out-of-pocket costs like taxes on cigarettes are used to change the behavior of consumers who smoke, as this causes harmful health effects.
  • It brings about a sharing factor between two parties where both parties contribute to an expense.

Disadvantages

  • The cash required must be brought upfront, and at times there may be a lack of availability of cash, which will fail the overall transaction.
  • Even though the medical insurance company promises to cover the health-related cost, there is a catch behind it where the 100% cost will never be covered as the concept of out-of-pocket expenses pitches in.
  • Some expenses, like the tax on smoking, may not prove fruitful for all when it comes to human behavior, as a person addicted to smoking will still smoke and instead pay more money for it.
  • They are not predictable and can, at times, disrupt the planning and budget of the individual concerned.

Out of Pocket Vs Deductible

In this context it is important to understand the differences between the two terms given above. Let us go through the same in details.

  • This concept will come when we take into consideration the medical insurance concept. Apart from the monthly or yearly premium we pay for the medical insurance policy, the deductible is the amount one needs to pay from one’s pocket for the insurance covered before the health insurer bears the medical cost. Thus, the amount the medical insurance will pay us will depend on two factors. First, whether the deductible has been paid or not, and second, based on the coinsurance percentage; thus, a deductible is an amount one must pay before the insurance company helps the policyholder.
  • Out of pocket is the maximum cost one must bear or pay for the medical care for the entire year. It includes deductibles, co-pays, and coinsurance up to a stipulated value or amount set by the insurance company. Typically, medical insurance policies with a low deductible and out-of-pocket expenses will come with a hefty premium. The premium, though, doesn’t fall under the out-of-pocket costs as that is the regular cost that one has to bear monthly or yearly to maintain the medical insurance coverage.

Out-of-pocket expenses have both advantages and disadvantages. While some are reimbursed by the company or business, in health insurance cases, these are strictly non-reimbursable. Typically, in of out of pocket expenses in accounting, medical insurance policies with a low deductible and out-of-pocket expenses will come with a hefty premium. In business, it can be the employee’s spending which one has spent for business- or work-related purposes first out of their pocket, and then these get reimbursed by the company or business. At times these are also implemented to bring about changes in behavior, for instance, in the field of smoking as a tax on cigarettes, but then again, it depends on person to person on how they react to it.

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