An FSA allows an employee to set aside a designate portion of his or her earnings on a pre-tax basis to pay for qualified expensesas set forth by IRS guidelines. Most commonly used to pay for medical out-of-pocket expenses but often use too forpermissible dependent care expenses. Money deducted from an employee's pay into an FSA is not subject to payroll taxes, resulting in a substantial payroll tax savings for both the employee and the employer.

The most common type of FSA, the Health FSA is used to pay for medical expenses not paid for by insurance; this usually means deductibles, copayments, and coinsurance for the employee's health plan, but may also include expenses not covered by the health plan, such as dental and vision expenses and eligible over-the-counter (OTC) medications, including a first aid items.

A Health FSA cannot pay for health insurance premiums, cosmetic or toiletry items, cosmetic surgery, controlled substances (in violation of federal law), or items that improve "general health". All items must be intended to treat or prevent a specific medical condition—this can be as significant as diabetes or pregnancy, or as minor as skin cuts. Generally, allowable items are the same as those allowable for the medical tax deduction, as outlined in IRS publication 502.

Generally used in conjunction with a health savings account (HSA), a Limited Purpose FSA offers the same tax advantages as the Health FSA, but the use of the funds are, as the name suggests, more limited to reimburse employees for designated eligible expenses such as for dental, vision, over-the-counter or preventative care expenses.

When being used in conjunction with contributing to the HSA bank account, additional medical expenses may also be reimbursed using the limited purpose funds; however, they may only be reimbursed after the IRS-mandated minimum deductible has been met.

FSAs can also be established to pay for certain expenses to care for dependents that live with you while you are at work. While this most commonly means child care, for children under the age of 13, it can also be used for adult day care for senior citizen or adult dependents that live with you, such as parents. Funds cannot be used for summer camps (other than "day camps") or for long term care for parents that live elsewhere (such as in a nursing home).

The dependent care FSA is federally capped. While married spouses can each elect to have an amount deducted from their paycheck and applied to expenses, at tax time all withdrawals in excess of the federal cap are recaptured for tax purposes. If married, BOTH spouses must earn income in order for the Dependent Care FSA to work. The only exception is if the non-earning spouse is disabled or a student. If one spouse earns less than $5,000 then the benefit is limited to whatever that spouse earned.

Unmarried couples can each deduct and use up to the federal cap. However, these expenses are subject to the "qualifying child" rules, which usually means unmarried couples cannot pay expenses for the same child. 

Some employers choose to issue a debit card to their employees who participate in the FSA. Participants may use the debit card to pay for their FSA-eligible expenses at the point of sale—giving each participant immediate access to their benefit dollars. Pharmacies and grocery stores who choose to accept the debit card as payment must disallow transactions at point of sale if the participant attempts to pay for items that are not eligible under an FSA. In addition, employers still must require employees to provide itemized receipts for expenses paid with the debit card when the expense can not be electronically substantiated.

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