Service dogs are invaluable aids to many people with disabilities, but is the cost of the dog deductible?

IRS Publication 502 gives the answer that service dog expenses are tax deductible:

"You  can  include in medical expenses the costs of buying, training, and maintaining a guide dog or other service animal to assist a visually-impaired or hearing-impaired person, or a person with other  physical  disabilities."

Tax law does require that the expense must be for a mitigation related to the diagnosed medical condition and not merely the general health of an individual.

If you are visually impaired and have dog to guide you, then your expense is proven. However, the IRS explanation above discusses “physical” disabilities, rather than mental disabilities. This definition left those with mental disabilities in a gray area. But if your doctor prescribes the animal and links it to a specific disabling mental condition, the IRS would probably accept it. The general rule for deducting a medical expense is "Medical care expenses must be primarily to alleviate or prevent a physical or  mental  defect or illness. They do not include expenses that are merely beneficial to general health, such as vitamins or a vacation."

Recently, the IRS removed the doubt about service dogs for those with mental disabilities when the IRS sent a letter to Congress. 

"A taxpayer who claims that an expense of a peculiarly personal nature is primarily for
medical care must establish that fact. The courts have looked toward objective factors
to determine whether an otherwise personal expense is for medical care: the taxpayer’s
motive or purpose for making the expenditure, whether a physician has diagnosed a
medical condition and recommended the item as treatment or mitigation, linkage
between the treatment and the illness, treatment effectiveness, and proximity in time to
the onset or recurrence of a disease. Havey v. Commissioner, 12 T.C. 409 (1949). The
taxpayer also must establish that the expense would not have been paid “but for” the
disease or illness. A personal expense is not deductible as medical care if the taxpayer
would have paid the expense even in the absence of a medical condition.
Commissioner v. Jacobs, 62 T.C. 813 (1974).
The costs of buying, training, and maintaining a service animal to assist an individual
with  mental disabilities  may qualify as medical care if the taxpayer can establish that the
taxpayer is using the service animal primarily for medical care to alleviate a mental
defect or illness and that the taxpayer would not have paid the expenses but for the
disease or illness.
(Letter to Rep. Tanner, Index Number: 213.00-00, 06/25/2010.)

Following the rules listed in this letter should enable you to prove the deduction.

Another possibility is that if you have a service dog to help with a mental disability, you may be able to claim the animal under “impairment-related work expenses.”  The work deduction is less limited than the medical deduction if it qualifies, but for you to be considered disabled so as to claim an impairment-related work expense, you must have a physical or mental disability that functionally limits your being employed, or a physical or mental impairment that substantially limits one or more of your major life activities such as performing manual tasks, walking, speaking, breathing, learning, or working. 

Note that the new ADA regulations which became effective March 2011 define service dog:

Any dog that is individually trained to do work or perform tasks for the benefit of an individual with a disability, including a physical, sensory, psychiatric, intellectual, or other mental disability. Other species of animals, whether wild or domestic, trained or untrained, are not service animals for the purposes of this definition. The work or tasks performed by a service animal must be directly related to the handler´s disability. Examples of work or tasks include, but are not limited to, assisting individuals who are blind or have low vision with navigation and other tasks, alerting individuals who are deaf or hard of hearing to the presence of people or sounds, providing non-violent protection or rescue work, pulling a wheelchair, assisting an individual during a seizure, alerting individuals to the presence of allergens, retrieving items such as medicine or the telephone, providing physical support and assistance with balance and stability to individuals with mobility disabilities, and helping persons with psychiatric and neurological disabilities by preventing or interrupting impulsive or destructive behaviors. The crime deterrent effects of an animal´s presence and the provision of emotional support, well-being, comfort, or companionship do not constitute work or tasks for the purposes of this definition.

Dogs may also qualify under IDEA, the Individuals with Disabilities Education Act.
 
Update, February 25, 2017:

The U.S. Supreme Court on Wednesday ruled that the family of a Michigan girl with cerebral palsy can pursue a disabilities suit against her school for banning her service dog, in Fry v. Napoleon Community Schools.

Based on the lawsuit allegations, the family was not required to exhaust administrative remedies under the Individuals with Disabilities Education Act before suing.

The Elementary School had banned the service dog, a goldendoodle named Wonder, in 2009, though it later relented. The school district had reasoned that Wonder didn’t need to help the girl, identified as E.F., because she already had a human aide. Wonder was trained to help E.F. retrieve dropped items, open and close doors, turn on and off lights, and take off her coat. E.F.’s pediatrician had recommended the dog stay with E.F. at all times to increase bonding.

The family’s suit against the school district suit relied on the Americans with Disabilities Act and the Rehabilitation Act, rather than the IDEA law.

The court said exhaustion wasn’t necessary because the substance of the suit wasn’t based on a denial of the IDEA law’s guarantee of a free appropriate education. She remanded the suit, however, for a determination whether the family had sought remedies under the IDEA law before filing the suit.