I have a water damaged iphone 4s and I heard the Out of warranty service is $199. But the apple store worker told me that I can't have it replaced for $199 because I am not eligible for an upgrade. This does not make any sense to me... I have to be eligib

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If you have an iPhone 4S and you need a replacement iPhone 4S, you will have to pay $199 for it, and this is the same case for everybody, so I don't know why the Specialist or Genius didn't allow you to get a replacement iPhone 4S.

I would try to take it in again and see what happens. If they refuse to offer you one, contact with Apple directly > http://support.apple.com/kb/HE57

No, you were told wrong.

The out of warranty or not covered under the warranty service is an exchange - the damaged iPhone is exchanged with the same model, storage capacity, and color which has nothing to do with being eligible for an upgrade.