The standard first states a broad definition of unallowable costs as "any cost which, under the provisions of any pertinent law, regulation or contract cannot be included in prices, cost reimbursements or settlements under a Government contract". The definition is broad enough to include not only costs prohibited by specific FAR cost principles but also any cost to be excluded from a contract price such as expenses a contract may exclude, costs incurred in excess of contract value or limits set by the "Limitation of Funds" clause. Within the broad definition, the standard creates three categories of unallowable cost.

1. "Expressly Unallowable" Costs. These are expenses where an applicable law, regulation or contract is specifically named to be unallowable. It is intended to be unmistakable.

2. "Mutually Agreed to be Unallowable" Cost. This is a cost that does not fit the definition of "expressly unallowable" but, nonetheless, the parties have mutually agreed to be unallowable.

3. Costs "Designated to be Unallowable by a CO's Written Decision". This cost is in dispute and falls under this category when the CO makes a written determination of its allowability. Once a final decision is made (agreement between the parties, Court or Appeals Board) the cost becomes one of the two other categories or, if determined to be allowable, CAS 405 no longer applies. The purpose of this cost category is to allow the contractor to continue claiming such costs in spite of an adverse opinion and to alert the parties of the need for special consideration of the cost.

In addition to the three categories above, there are costs (a) related to unauthorized work that though not unallowable per se, requires they be identified and accounted for in a manner permitting they be separated from authorized work (b) that cannot be determined at the time they were incurred (e.g. defense of a fraud case where allowability depends on the outcome of a case that may not be known for years) (c) deemed to be unallowable by virtue of them being unallocable and (d) that are "directly associated costs", which are costs generated solely as the result of another cost and would not have been incurred had not the other costs been incurred. The Standard presents an example of the last type of cost where normally allowable costs of travel and expense would be made unallowable if the trip was for entertainment purposes.

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