What Is a Discretionary Bonus?

What is a discretionary bonus?

A discretionary bonus is a form of additional compensation an employer independently decides to give to an employee without the employee expecting it; it’s beyond the scope of the employment contract. While a discretionary bonus is considered part of an employee’s compensation, it’s typically not attached to a specific goal or expectation. Similarly, no predefined dollar amount or timeline is communicated to the employee before the bonus is awarded.

Discretionary bonuses are often unplanned or awarded based on subjective judgment. There should be no connection between the bonus and a prior promise, contract or agreement with the employee.

To qualify as truly discretionary under federal regulations, the U.S. Department of Labor defines that the employer must maintain sole discretion both in determining whether to award the bonus and the amount, until at or near the end of the period corresponding to the bonus.

Rachel Richey emphasized that discretionary bonuses are a powerful tool for recognizing employee contributions and creating a strong company culture. “When used thoughtfully, they not only motivate employees but also reinforce behaviors aligned with organizational goals,” Richey, director of human resources at Off Duty Services, explained. “These bonuses can demonstrate an organization’s commitment to valuing its people, ultimately driving engagement, retention and overall effectiveness.”

Discretionary vs. nondiscretionary bonus

Unlike discretionary bonuses, nondiscretionary bonuses are contingent upon the employee meeting specific qualifications. The employer sets the criteria in advance and informs the employee of the requirements they must fulfill to receive the bonus.

Examples of nondiscretionary bonuses include hiring bonuses and bonuses for meeting employee performance goals. An incentive pay plan is another type of nondiscretionary bonus; it sees an employee qualify for the bonus by meeting established performance or productivity targets.

FLSA implications

The Fair Labor Standards Act (FLSA) defines which employees are eligible for overtime pay. Offering employees bonuses can retroactively increase their regular compensation, which may require the employer to pay additional overtime. The rules for overtime pay depend on an employee’s classification:

• Exempt employees earn an annual salary and are expected to complete assigned tasks, regardless of how long it takes each week.
• Nonexempt employees must be paid 1.5 times their hourly rate for each hour worked beyond a full 40-hour workweek.

Let’s say an employer gives a nondiscretionary bonus to a nonexempt employee and it increases the employee’s hourly rate. In this case, the employer must factor the nondiscretionary bonus into calculating the employee’s blended overtime pay for the time during which the bonus applies. A bonus is nondiscretionary if the employer sets any benchmarks an employee must hit before paying out the bonus — even if the employer decides the bonus amount afterward.

Common uses and examples of discretionary bonuses

Employers may award an employee a discretionary bonus for various reasons, including the following:

• Overcoming a challenging situation
• Demonstrating exceptional performance not awarded under other specified criteria
• Going beyond their usual duties
• Being selected as employee of the month/quarter
• Expressing holiday or year-end appreciation
• Referring a new employee

Spot, referral, retention and holiday bonuses are among the most popular types of discretionary bonuses. Here’s more information about specific examples:

Spot bonuses

Spot bonuses are spontaneous rewards given immediately after an employee demonstrates exceptional performance or goes above and beyond their regular duties. These unplanned bonuses serve as instant recognition and can significantly boost employee morale when delivered timely.

Referral bonuses

Employers sometimes award referral bonuses to current team members for recruiting new employees. A referral bonus is discretionary if the following criteria are met:

• The employee voluntarily participates in the referral program.
• Recruitment of new employees does not take up a significant amount of the employee’s time.
• The employee solicits potential candidates during off-hours, involving only friends, relatives, neighbors and acquaintances.

Retention bonuses

Employers sometimes award retention bonuses to employees under very specific circumstances. Such instances can include a merger, acquisition or the need to complete a critical project. These bonuses are designed to provide continuity during periods of uncertainty regarding an employee’s ongoing employment. A retention bonus encourages employees to stay with the company until a specified date to ensure continued involvement in organizational priorities.

Holiday bonuses

Employers may award employee holiday bonuses at the end of the year during annual events or other special occasions. The bonus may be given as cash or a gift, depending on the employer’s usual practices and preferences.

However, if a holiday bonus becomes a standard and expected practice, it can be viewed as nondiscretionary and become contractual. A holiday bonus is nondiscretionary if it is:

• Clearly defined and guaranteed
• Consistently reasonable and fair
• Has been provided regularly over a significant period
• Reasonably expected to continue
• Applied consistently across employees

Legal and compliance risks to watch

While discretionary bonuses offer flexibility and motivation benefits, they come with several legal and compliance considerations that employers must carefully navigate. Understanding these risks helps prevent costly violations and ensures your bonus program remains compliant with federal and state regulations.

Misclassification risks

One of the primary legal risks involves misclassifying bonuses. If an employer consistently awards what they call “discretionary” bonuses under similar circumstances or based on implied expectations, these payments may be deemed nondiscretionary by regulatory agencies. This reclassification can result in overtime calculation errors and potential wage and hour violations.

Overtime calculation complications

While truly discretionary bonuses don’t typically require recalculation of overtime rates, employers must ensure their bonus programs meet strict federal criteria. Any bonus that becomes expected or is tied to performance metrics must be included in overtime calculations for nonexempt employees, potentially creating unexpected payroll costs.

Morale and equity concerns

Discretionary bonus programs can inadvertently create workplace tensions if employees perceive unfairness in distribution. Without clear guidelines, these programs risk appearing discriminatory or arbitrary, potentially leading to employee relations issues or legal challenges.

How to create a discretionary bonus plan

When creating a discretionary bonus plan, you’ll need to: decide how to fund it, calculate your bonuses and ensure several best practices for legal compliance.

Funding discretionary bonuses

Bonuses require budget planning. The employer should budget for the total amount of discretionary bonuses that can be awarded in any given period. This can involve creating a funding pool and determining the range of amounts that can be allocated to employees after a specific performance period.

Calculating discretionary bonuses

Employers can give a set amount for a discretionary bonus based on how much funding is available. They can also calculate discretionary bonuses using different formulas:

• Percentage of sales: Multiply the employee’s total sales figures by a specific amount.
• Bonus per sale: Multiply a predetermined bonus amount by the number of sales the employee completes.
• Designated sum divided: Set a total amount for bonuses and divide it by the number of employees.
• Number of hours worked: Add each employee’s total hours and divide the total bonus by the total number of hours; this will determine an hourly rate. Multiply this rate by each employee’s number of hours worked.

Clarifying and documenting discretionary bonuses

When creating a discretionary bonus plan, ensure it is:

• Simple: Make the bonus plan straightforward. Management should understand when and how to apply discretionary bonuses, and employees should understand why they are receiving them.
• Equitable: The discretionary bonus should be fair for all employees. Every employee across all departments should be eligible to receive a bonus, and the amount of each bonus should be equitable and balanced.
• Timely: Pay bonuses within the pay period in which they are awarded. Discretionary bonuses should not be scheduled or awarded on specific dates known to employees; otherwise, they could be considered nondiscretionary. Vary the frequency of bonuses as necessary.
• Relevant: Bonuses should be meaningful to both management and employees. Employers should attach significance to the bonus to give the employee a greater sense of fulfillment and achievement.
• Material: A bonus should be of sufficient size so that the employee appreciates it. A cheap gift or very small financial bonus might insult the employee and decrease their motivation and appreciation.

Best practices in implementing discretionary bonuses

With your discretionary bonus plan in place, follow these steps to implement it.

1. Tell employees about the bonus plan.

If your employees are unaware of your bonus plan, it can’t motivate them. You can inform them in multiple ways, including via a company-wide email, an in-person employee meeting, or by including it in your employee newsletter or on your internal website. The communication should let employees know the details of how the bonuses will work, including how they can qualify to receive one. For example, by referring a new employee, doing outstanding work or performing the best work in their department in a specific month.

2. Include the bonus plan in the employee handbook.

By adding information about the discretionary bonus plan to your employee handbook, you accomplish two goals: You inform new hires about the bonus program and officially include it in your employee policy documents. If employees forget the details of the bonus program, they can always refer to the employee handbook for clarification.

3. Train managers on the bonus criteria.

Since managers will decide who receives discretionary bonuses — or at least give their input —  they must thoroughly understand the bonus criteria. Train managers on the requirements for awarding bonuses and clarify whether there’s room for their personal judgment in the decision-making process. Some bonuses, such as referral bonuses, are straightforward, while others, such as those for outstanding work, are more subjective.

4. Set up reviews to decide which employees qualify for bonuses.

Discretionary bonuses don’t have automatic triggers. So, leadership team members must review employees to evaluate who qualifies and who should receive them. These reviews should take place regularly, such as quarterly or monthly.

In any given review period, you may have more than one employee who meets the bonus criteria. If the bonus amount is relatively small, you may decide to award it to all employees who qualify. However, if it is more significant or based on a set period, you must carefully choose the recipient.

Daniel Space, senior HR business partner director and HR content creator at DanFromHR, stressed the need for fairness and caution when awarding discretionary bonuses. “The moment you offer a discretionary bonus, you set a precedent,” Space warned. “So, if another employee does something in equal measure, impact, scope, or delivery, and the bonus is not given or is of a different amount, it becomes a controversy if added nuances like gender, sex, nationality or other statuses are taken into account.”

To remove the perception of bias, Space suggested applying such bonuses as part of a reward program. “For example, either employees or managers can submit quarterly or monthly nominations and have a team made up of employees/managers/HR to review the nominations and determine which of the nominations is most deserving,” Space explained. “This doesn’t fully remove bias, but it does allow for an element of rigor and consistency in the approach.”

Jennifer Dublino contributed to this article. Some source interviews were conducted for a previous version of this article.