Introduction to the Human Resources Discipline of Compensation



Overview

Direct compensation refers to wages paid by employers to employees in exchange for work. Compensation also includes variable pay in the form of short- and long-term incentives, such as cash bonuses, commissions and company stock awards. Employers must continuously review their internal compensation practices and be flexible and agile when it comes to employee pay practices to attract new hires and keep current employees on board.

Types of Compensation

Base Pay

Wages and salary are commonly known as base pay. Base pay is the foundation of total compensation because it establishes the standard of living for employees. It also serves as the primary indication of the value the organization places on the role an employee plays and on the contributions the employee makes. For base pay rates to be effective, both the organization and employees must view them as being internally equitable, externally competitive, affordable and cost-effective, legal and defensible, understandable, and appropriate for the organization and for the workforce.

Variable Pay

Variable pay is a significant element of the direct compensation package in a growing number of organizations. Variable pay can be in the form of short-term (one year or less) or long-term (two years or more) incentives or bonuses and employee ownership programs. See Designing and Managing Incentive Compensation Programs.

Short-term incentive plans often include:

• Gain-sharing or profit-sharing plans.
• Annual incentive plans.
• Commission plans.
• Cash recognition awards.

In most short-term variable pay plans, participants have a target—typically a percentage of base pay—that is paid out when the individual, team, business unit or organization meets a goal or combination of goals. Over-target payouts may occur when objectives are exceeded. According to a 2021 WorldatWork survey, employers typically spend 7 percent of operating income on short-term incentives. See Use Variable Pay to Retain Top Performers.

Sales employees are often compensated with commissions, either exclusively or in combination with base pay. The main purpose of a sales compensation plan is to motivate sales professionals to achieve specific objectives that directly translate to the organization's bottom line. See Designing Compensation Systems for Sales Professionals.

One of the objectives of long-term incentive plans is to retain key employees by vesting a percentage of the plan award over a number of years. In addition to cash plans, employers can choose from a variety of stock-based plans, including stock option, restricted stock and performance-based stock plans. Although often used as a type of incentive for executives, many employers use equity compensation throughout the organization. See Stock Plans Increase Savings, Attract Millennials, Studies Show and ESOPs Remain Attractive for Companies Seeking to Engage Workers.

Differential pay

Employees are paid a premium over their regular wages and incentives in many other situations. Organizations often pay a differential to employees when they are required to work under certain conditions such as evening or night shifts or in unusually cold, warm or dangerous environments. See What are some common types of differential/premium pay?

Organizations may also offer additional pay to employees who perform a lead function or to employees who are on call after regular working hours for emergency or highly specialized situations. See How should we pay on-call, nonexempt employees for the time they are not actually working when on call?

Compensation Infrastructure

To manage compensation efficiently and cost-effectively, a compensation infrastructure is developed. At a minimum, the compensation infrastructure consists of the following:

• A compensation philosophy.
• A review of each job/role and its worth in the organization.
• A set of pay ranges to guide managers in making hiring offers and in promotional, merit and other pay increases.

Compensation philosophy

Development of the compensation philosophy—a statement about how the organization manages compensation—is an important first step in creating the compensation infrastructure. A typical compensation philosophy might state that the organization sets target pay rates at the 50th percentile of the competitive market, provides incentives for meeting stretch goals that result in pay delivery at the 75th percentile, and provides long-term incentives in the form of full-value stock options to senior professionals and managers to align objectives with those of shareholders. The compensation philosophy provides guidance to compensation professionals in the initial setup and ongoing maintenance of the compensation infrastructure.

See:

What is a compensation philosophy? What should be included in a compensation philosophy?

What are the advantages or disadvantages of a lead, match or lag compensation strategy?

Compensation equity

Pay structures are designed to reflect the characteristics of an organization, attract qualified applicants and retain top employees. A proactive approach to employee compensation considers not only an organization's mission, business strategy and culture, but also the legal framework prohibiting wage discrimination in the workplace. Supporting equal pay for equal work, with allowable pay differences based on factors not prohibited by law, and promptly addressing any improper pay disparities, is essential.

Job analysis

Maintaining a description of jobs and associated pay grades is a key role for the compensation analyst in many organizations. Job analysis is the systematic study of jobs to determine the activities and responsibilities they include, their relative importance in comparison with other jobs, the personal qualifications necessary for performance of the jobs and the conditions under which the work is performed. Job analysis focuses on the job, not the person doing the job (even though some job analysis data may be collected from incumbents).

The most effective job analysis technique, if feasible, is to collect information directly from the most qualified job incumbent(s) via an open-ended or highly structured questionnaire. Other methods include observation, interview, or work diary or log.

Employers can use job analysis data to identify the knowledge, skills and expertise required to effectively perform job assignments, establish criteria for selection and promotions, design objectives for training and development programs, develop the standards for the measurement of performance, and assist with the determination of pay classification levels. A valuable output from the job analysis process is information that HR can use to develop job descriptions and job specifications. See How do I conduct a job analysis to ensure the job description actually matches the duties performed by the employee in the job?

Job evaluation

After the job analysis is complete, employers must decide about job pricing. If the organization is most concerned with being competitive with other employers regarding pay, the next step would be market pricing. On the other hand, if the organization is most concerned with internal equity, the next step would be job evaluation. See Performing Job Evaluations.

The job evaluation process determines the relative worth of each job by establishing a hierarchy of jobs within an organization and is the key to establishing a fair and equitable pay structure. Job evaluation methods can be quantitative, qualitative or a combination of both.

Nonquantitative job evaluation methods attempt to establish a relative order to jobs, whereas quantitative methods attempt to establish how much more one job is worth compared with another job by using a scaling system. Numerous different job evaluation systems are now in use. Each uses one of about a dozen technical approaches such as the factor comparison, point-factor, job component, definition, ranking or slotting methods to determine the value of each job in the organization.

Market pricing

Market pricing is the process of setting pay structures almost exclusively by collecting, analyzing and matching job salary survey data to determine rates paid in the external market. See Building a Market-Based Pay Structure From Scratch.

Organizations may elect to use this method across the board or just for certain professions that are market-driven (e.g., information systems, engineering).

A salary survey collects information on base pay (salary), recent or projected pay adjustments, bonuses or bonus eligibility, or other forms of compensation on selected jobs across or within occupational fields for a labor market defined by its industrial scope, geographical reach (local, regional, national or international) and other characteristics.

Location-based compensation strategies are increasing as more employees perform their work remotely. Some employers are choosing to adjust pay based on the employee's work location rather than the location of the company's main office or a U.S. national average. See Select a Pay Strategy for Remote Workers.

HR professionals and compensation specialists use survey data to help develop pay structures, price jobs, advise on salary offers, forecast wage movement, formulate performance pay matrices, prepare salary budgets, support labor contract negotiations and perform other work requiring sound information on competitive compensation. See SHRM Compensation Data Center.

Due to antitrust regulations, organizations should avoid direct comparisons of pay and salary data with competitors (i.e., they should not contact other employers directly to ask what they pay for a particular job). Third-party salary surveys through professional associations, professional societies or consulting groups are recommended to avoid any implication of conflict in this regard. See Can I contact other local organizations in my area to get a gauge on merit projections or other compensation and benefits data?

Pay ranges

The result of pricing is a target pay rate for each job within the organization. Once the target pay rate is determined, the next step is to develop pay ranges to provide managers with a range of pay for each job. Ideally, managers use the pay range to manage pay relative to performance and experience in the job.

An employer may choose traditional pay structures or broadbanding to organize the pay bands related to jobs. Traditional pay structures tie a range of pay to a cluster of jobs with the midpoint of the range corresponding to the theoretical market competitive rate. In broadbanding, employers have fewer ranges, but they are wider, accommodating more jobs and encouraging lateral moves within the organization. See How to Establish Salary Ranges.

A useful tool for managers to assess internal equity or appropriateness of an individual's pay relative to performance and experience is the compa-ratio. A compa-ratio is a measure that expresses current pay rates as a percentage of range midpoints. For an individual at the midpoint of the range, the compa-ratio is 1.0, whereas someone at the minimum might have a compa-ratio of 0.8, and someone at maximum a compa-ratio of 1.2. See Compa-Ratio Calculation Spreadsheet.

Pay Actions

A key area of responsibility within compensation involves proposing the annual pay increase budget. The overall merit pay budget for the year is planned using market data and organizational performance. Once the budget is set, managers must decide how to allocate the budget across the organization. A salary management guide is helpful for this purpose. Such a guide reflects the relationship between employee performance, employees' current position within the pay range and the budget for merit increases. See Merit Increase Matrix.

Pay actions provide for adjustments to the pay of employees to preserve competitiveness and reward performance. Pay actions most often occur either on a single (focal) date or throughout the year. In a focal point review system, all employees receive performance and merit increase reviews on a common date. Anniversary date increases are usually on the anniversary date of employment or promotion.

When organizations use individual pay increases to motivate employees and reward high-performers, the pay system is based on performance. Regardless of whether a focal point or anniversary schedule is used, employers must coordinate timing of the performance appraisal and the salary action. If an employee is to believe pay is tied to performance, a visible connection must exist, and long periods of time between the performance review and the salary action diminish the connection.

In a shift from cost-of-living increases, which some employees view as entitlements, employers are finding it more effective to reward top performers with merit increases and performance bonuses and incentives. Pay increases based on performance are representative of an employee's ongoing and potential contributions. Much can be learned from best-practice organizations where base pay increases must be earned, based on demonstrated individual achievement. See Use Variable Pay to Retain Top Performers.

One way to differentiate base pay increases or bonuses for high performers is by carving out a portion of the pay increase or variable pay/bonus budget for employees who are designated as high performers. See Reward Top Performers Even in Lean Times.

In a person-based pay system, pay is based on what the employee brings to the organization in the form of knowledge, skills, abilities and behaviors. Three approaches tie base pay to what people have in the way of qualifications:

• Skill-based. Skill-based pay makes the base rate contingent on how many job-related skills the employee has learned, the level of skill mastery or a combination of both.
• Knowledge-based. Knowledge-based pay typically centers on career ladders, which identify expertise levels within the same occupation or discipline.
• Credential-based. Credential-based pay recognizes formal credentials such as licenses, professional certifications, admission to the bar and other such formal designations as a basis for determining pay.

Specialized Compensation Categories

Some types of compensation require specialized planning and design. These include:

• Executive compensation.
• Global compensation.
• Sales compensation.

Executive compensation

Executive compensation typically applies to the top 2 percent to 5 percent of an organization's workforce. In addition to base pay and short- and long-term incentive pay, executives are often eligible for other compensation elements such as deferred compensation and perquisites. Executive perks might include a reserved parking place, a comprehensive annual physical exam, tax planning, first class airfare or use of a company car. See Designing Executive Compensation Plans and Should Employers Tie Executive Compensation to DE&I Goals?

Global compensation

Global compensation pertains to the planning and administration of pay programs for domestic and expatriate employees located in organizational offices around the world. Employers must understand the culture, competitive practices and employment laws of each country where the organization operates to avoid costly mistakes. See Designing Global Compensation Systems.

Sales compensation

Sales compensation applies to pay programs for sales employees and managers. Sales compensation is distinct from nonsales variable pay plans in that the sales compensation plan ideally supports the overall marketing and sales plan for the organization directly. As a result, the sales force has a direct and measurable impact on the employer's overall sales/revenue. Because of this link, a larger percentage of a salesperson's total cash compensation is typically put at risk. See Designing Compensation Systems for Sales Professionals.

Legal and Regulatory Issues

The U.S. Department of Labor (DOL) Wage and Hour Division oversees compliance with the Fair Labor Standards Act (FLSA) which regulates minimum wage, overtime eligibility and the employment of minors.

Minimum wage is defined as the smallest hourly wage that an employee may be paid for all hours worked, as mandated by federal or state law. See State Minimum Wage Laws.

Overtime pay is the term used to define compensation for work in excess of 40 hours per week (a defined, seven-consecutive-day period) in accordance with the FLSA. Some states have daily overtime laws as well. The FLSA categorizes workers in the United States into two groups: those who are eligible for overtime pay (nonexempt) and those who are exempt from the requirement to pay overtime. Nonexempt employees are paid time-and-a-half of their regular rate for overtime hours. Exempt employees are paid a fixed salary for their contribution to the organization without any entitlement to extra pay for extra hours worked.

The child labor provisions of the FLSA and state laws are designed to protect the educational opportunities of youths and to prohibit youth employment in jobs and under conditions detrimental to their health and well-being. See U.S. DOL Child Labor.

The Equal Pay Act of 1963 is part of the FLSA and is administered and enforced by the Equal Employment Opportunity Commission (EEOC). The act prohibits sex-based wage discrimination. That is, men and women in the same establishment, who are performing work requiring equal skill, effort and responsibility and are performing under similar working conditions, may not be paid differently based on gender. Employers that violate the act may not reduce the wage rate of any employee to comply with the act. See Managing Pay Equity. Voluntary self-evaluations of pay provide employers with an opportunity to proactively address discrepancies in pay equity. A thorough evaluation of any existing differences in pay includes examination of the cumulative results of past pay decisions. An employer's good-faith evaluation of pay practices, combined with proactive efforts to eliminate any improper pay differences, may contribute to an affirmative defense to liability against a claim of pay discrimination. See Pay Equity Audits and Transparency Foster Trust, SHRM Research Shows and Keeping Bonus Programs Fair and Equitable.

The U.S. Department of Labor (DOL) has published extensive resources to help employers with various wage and hour matters. The FLSA Advisor and Frequently Asked Questions provide information about the minimum wage, overtime pay, child labor and record-keeping laws.

Careers in Compensation

Although the responsibilities related to compensation are often performed by a human resource manager or generalist in small organizations, larger employers frequently have a compensation department within human resources. Compensation is staffed with one or more compensation analysts (also called specialists or consultants). Specialized certifications may be needed to move into career or senior levels of the profession.

See:

Compensation, Benefits, and Job Analysis Specialists

SHRM Specialty Credentials

Preparing for a Career in HR

Related Resources

In addition to this broad introduction to employee compensation, see SHRM's toolkits on other compensation topics:

Compensation planning and design

Building a Market-Based Pay System from Scratch

Performing Job Analysis

Performing Job Evaluations

Designing and Administering Severance Pay Plans

Designing Global Compensation Systems

Designing and Managing Incentive Compensation Programs

Designing Compensation Systems for Sales Professionals

Designing Executive Compensation Plans

Using Overtime Effectively

Legal and regulatory Issues

Complying with U.S. Wage and Hour Laws and Wage Payment Laws

Managing Pay Equity

Understanding Overtime Exemptions Under the FLSA

Calculating Overtime Pay in the United States

Tools and Samples

Merit Increase Policy and Procedure

Performance and Salary Review Policy

Merit Increase Matrix