In California, cash in lieu of benefits is legal, but only when the employer routes the payment through a written Section 125 cafeteria plan, treats the money as fully taxable wages, and folds it into the regular rate used to calculate overtime. Handled loosely, the same payment can blow up a company’s Affordable Care Act affordability calculation and create years of wage-and-hour exposure.
Why a Section 125 Plan Is the Starting Point
Giving employees a choice between health coverage and cash creates a tax problem the moment the choice exists. Under the doctrine of constructive receipt, an employee who could have taken cash but chose benefits instead is treated as having received the cash for tax purposes. That would make every employee’s health premiums taxable, not just the payments to those who opted out.
A Section 125 cafeteria plan is the only structure that prevents that outcome.1Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans Federal law defines a cafeteria plan as a written plan in which all participants are employees and each participant chooses between cash and qualified benefits.2Office of the Law Revision Counsel. 26 US Code 125 – Cafeteria Plans The word “written” is doing real work. A formal plan document has to spell out the benefits offered, contribution rules, participation requirements, and nondiscrimination provisions. Handing out cash to whoever declines coverage, with no plan document behind it, risks making every employee’s health benefits taxable. The plan also has to pass annual nondiscrimination testing so it doesn’t tilt toward highly compensated employees.
The ACA Affordability Trap
This is where most employers get caught. Applicable large employers (generally 50 or more full-time employees) must offer coverage that counts as “affordable” under the ACA. For 2026, coverage is affordable if the employee’s share of the self-only premium doesn’t exceed 9.96% of household income.3Internal Revenue Service. Rev Proc 2025-25 Certain opt-out payments effectively push the employee’s cost of coverage up for that calculation.
The IRS splits opt-out arrangements into two categories. An unconditional opt-out payment asks nothing of the employee beyond declining coverage. The IRS treats these payments as increasing the employee’s required contribution for affordability purposes.4Internal Revenue Service. Notice 2015-87 If an employee pays $200 a month toward premiums and the employer dangles a $300 monthly opt-out payment, the IRS views the real cost of coverage as $500. That higher figure makes the affordability test much harder to pass.
Failing matters. For 2026, an employer offering unaffordable coverage faces a penalty of up to $5,010 per year for each full-time employee who takes a premium tax credit through the marketplace. An employer that offers no coverage at all faces $3,340 per full-time employee, minus the first 30. Both figures are indexed annually, and a modest opt-out payment can be what tips the calculation.
How to Structure an Eligible Opt-Out
Under IRS proposed regulations, an “eligible” opt-out arrangement stays out of the affordability calculation entirely. To qualify, the arrangement must meet all of the following:
- The employee provides reasonable evidence that they and their tax dependents have or will have minimum essential coverage from a source other than the individual marketplace, such as a spouse’s employer plan, Medicare, or Tricare.
- The employer cannot make the payment if it knows or has reason to know that the employee or a family member lacks the required alternative coverage.
- The employee provides fresh evidence of alternative coverage at least once per plan year, typically during open enrollment.
A written attestation from the employee counts as reasonable evidence, though employers can ask for more.4Internal Revenue Service. Notice 2015-87 Conditioning the payment on verified other coverage is what turns an unconditional arrangement (bad for affordability) into an eligible one (neutral).
Opt-Out Payments Have to Be in the Overtime Rate
California employers regularly get this wrong. The Ninth Circuit resolved it in Flores v. City of San Gabriel, where police officers challenged the city’s practice of excluding unused benefit allowances from their overtime rate. The court held that cash-in-lieu payments have to be included in the regular rate of pay.5United States Court of Appeals for the Ninth Circuit. Flores v City of San Gabriel The ruling is binding in California.
The reasoning is straightforward. Federal law defines the regular rate as all compensation for work, subject to specific statutory exclusions.6U.S. Department of Labor. Fact Sheet 56A Overview of the Regular Rate of Pay Under the Fair Labor Standards Act One exclusion covers employer contributions “irrevocably made to a trustee or third person” for a bona fide benefit plan.7Office of the Law Revision Counsel. 29 USC 207 Money paid directly into the employee’s paycheck doesn’t fit. It goes to the worker, not irrevocably into a trust. So opt-out payments count as remuneration for employment and belong in the regular rate.
California’s Daily Overtime Makes This Bigger
California requires time-and-a-half after eight hours in a workday and double time after 12, on top of the federal 40-hour weekly trigger. Including opt-out payments in the regular rate therefore hits harder here than in states following federal rules alone, because the elevated rates come up more often.
The arithmetic is easy to run. Take an employee earning $25 an hour who receives $300 a month for waiving coverage. Across roughly 173 working hours in a month, that $300 adds about $1.73 to the hourly rate, lifting it to $26.73. Time-and-a-half becomes $40.10 instead of $37.50. Double time becomes $53.46 instead of $50.00. Multiplied across every overtime hour for every affected employee over three years, the shortfall grows quickly.
Employers that leave opt-out payments out of the regular rate underpay every overtime hour. The statute of limitations for California overtime claims runs three years, so a wage claim typically pulls years of payroll records.8Division of Labor Standards Enforcement. How to File a Wage Claim Back wages come with inaccurate wage statement penalties of up to $4,000 per employee.9California Legislative Information. California Labor Code LAB 226
Tax Treatment: These Are Wages
Employer-paid health premiums are generally excluded from taxable income. Cash paid instead of those premiums gets none of that treatment. Opt-out payments are ordinary taxable wages, subject to federal and California income tax withholding based on your filing status and bracket, and they show up as taxable wages on your W-2 at year end.10Internal Revenue Service. Employer Health Care Arrangements
Both sides also owe FICA: 6.2% Social Security up to the annual wage base and 1.45% Medicare with no cap. On $300 a month, the employee’s share leaves roughly $275 before income tax takes another cut. The employer additionally owes federal unemployment tax and California State Unemployment Insurance contributions.11Employment and Training Administration. Unemployment Insurance Tax Topic Employees weighing the cash against employer-subsidized coverage should run the after-tax number, not the sticker figure.
San Francisco Layers On Its Own Requirement
Employers with workers in San Francisco face a separate obligation. The Health Care Security Ordinance requires covered employers to spend a minimum amount per hour worked on health care for each employee.12San Francisco Municipal Code. San Francisco Health Care Security Ordinance For 2026, large employers (100 or more employees) must spend at least $4.11 per hour, and medium-sized businesses (20 to 99 employees) must spend at least $2.74 per hour.
A cash-in-lieu payment that falls short of the required hourly expenditure doesn’t satisfy the HCSO. The employer still has to make up the gap through the city’s health reimbursement program, a health savings account, or another qualifying expenditure. A $150 monthly opt-out payment for a full-time employee works out to about $0.87 per hour, far below the $4.11 large-employer threshold. Meeting one obligation doesn’t discharge the other, so San Francisco employers have to track both.
What a Compliant Program Looks Like
A cash-in-lieu program that survives scrutiny in California has several moving pieces working together. The choice between coverage and cash sits inside a written Section 125 cafeteria plan. The opt-out is structured as an eligible arrangement, conditioned on annual proof of other minimum essential coverage, so ACA affordability isn’t inflated. Payroll includes the payments in the regular rate used for both federal weekly overtime and California daily overtime. The payments run through W-2 wages with full income and payroll tax withholding. And for anyone with San Francisco employees, the HCSO minimum expenditure is tracked as a separate obligation. Treating the payment as a routine paycheck add-on, without addressing each of these pieces, builds compliance risk every pay period.