HCE vs. HCI: Why Employers Keep Mixing Up These Two Nondiscrimination Tests
This piece builds on our broader overview of Understanding Federal Nondiscrimination Laws for Group Health Benefits, which covers ERISA and HIPAA in more depth. Here, we’re zooming in on the IRS side of things.
If you offer a self-funded health plan or a Section 125 cafeteria plan, you are subject to federal nondiscrimination testing. The problem is that two very similar-sounding terms, Highly Compensated Employee (HCE) and Highly Compensated Individual (HCI), apply to two different tests with two different definitions. Mixing them up is one of the most common compliance mistakes we see among mid-market employers heading into renewal season.
This guide breaks down where each term applies, why the distinction matters, and what to check before your 2027 plan year locks in.
Where This Fits in the Bigger Compliance Picture
Group health benefits are governed by three federal laws: ERISA, HIPAA, and the Internal Revenue Code. ERISA protects an employee’s right to participate in a plan without retaliation, and HIPAA prevents plans from charging different premiums or denying eligibility based on health status. Both are covered in more detail in our companion piece.
The IRS rules are where things get more technical, because two different tests apply depending on how the plan is funded and how employees pay for it. That’s where HCE and HCI come in, and where the confusion starts.
The Real Source of Confusion: Section 105(h) vs. Section 125
This is where most employers get tripped up, and it is worth slowing down on. Two different IRS tests apply depending on how your health benefit is funded and how employees pay for it, and each test uses its own definition of “highly compensated.”
Section 105(h): Self-Funded Medical Plans Use HCI
If your medical plan is self-funded, it must pass nondiscrimination testing under Code Section 105(h). This test exists to stop self-funded plans from quietly favoring their most highly paid people in eligibility or benefit levels.
The relevant term here is Highly Compensated Individual (HCI), which generally includes:
- One of the five highest-paid officers
- A shareholder who owns more than 10 percent of the company’s stock
- Someone in the highest-paid 25 percent of all employees
Section 125: Cafeteria Plans Use HCE
If employees pay for benefits pre-tax through a Section 125 cafeteria plan, the cafeteria plan arrangement itself has to pass a separate nondiscrimination test. This one uses Highly Compensated Employee (HCE), a different IRS definition that generally includes:
- A 5 percent owner of the company, directly or indirectly, regardless of pay, or
- An employee whose compensation exceeded the IRS threshold during the lookback year
For plan years beginning in 2027, an employee is an HCE if they earned more than $160,000 in 2026, the lookback year. Pre-tax election administration is typically handled as part of a broader HRIS setup.
Why It Matters That These Are Not the Same Thing
Here is the part that catches employers off guard: a single company can be running both tests at the same time on the same group of employees, and getting a different answer from each one.
| Section 105(h) | Section 125 | |
|---|---|---|
| Applies to | Self-funded medical plans | Pre-tax cafeteria plan elections |
| Term used | Highly Compensated Individual (HCI) | Highly Compensated Employee (HCE) |
| Who counts for 2027 | Five highest-paid officers, 10%+ shareholders, or top 25% of pay | More than $160,000 in 2026 compensation (or 5%+ ownership) |
| What it tests | Eligibility and benefit levels under the medical plan | Pre-tax election access under the cafeteria plan |
Assuming that clearing one test automatically clears the other is a common and avoidable error. Treat them as two separate compliance checks, each run against its own definition of highly compensated.
Key Takeaways Before Your Next Renewal
- Self-funded medical plans are tested under Section 105(h) using the HCI definition.
- Pre-tax cafeteria plan elections are tested under Section 125 using the HCE definition, which for 2027 plan years covers employees who earned more than $160,000 in 2026 or own 5% or more of the company.
- Plan design changes are allowed, but they must apply consistently across the workforce and never target individuals based on health status or cost.
Get Your 2027 Plan Design Reviewed
Running the wrong test, or only one of the two, is an easy way to fall out of compliance without realizing it. Parker Insurance works with mid-market employers to review self-funded and cafeteria plan designs ahead of renewal, so your benefits stay compliant and still work for the people using them.
Contact Parker Insurance to review your 2027 plan design.
