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Updated Oct 13, 2023

What Is a Discretionary Bonus?

If you decide to offer compensation beyond employees' agreed-upon salary or wages, it's important to understand the tax implications and regulations of doing so.

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Written By: David GargaroSenior Writer & Expert on Business Operations
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As a business owner, you need to have a compensation plan that will motivate employees to do their absolute best by putting in maximum effort, creativity and time to accomplish the company’s goals. Discretionary bonuses are an excellent way to boost that motivation and recognize your team for a job well done. Should you use discretionary bonuses in your business, and if so, how can you implement them? Keep reading to find out.

What is a discretionary bonus?

A discretionary bonus is a form of additional compensation that the employer independently decides to give to an employee without the employee expecting it. The discretionary bonus is not attached to the employee’s achievement of specific expectations or goals. Nor is there a specific dollar amount or deadline indicated before the employer awards the bonus to the employee.

The employee should not expect a promise of payment when receiving a discretionary bonus; it should be somewhat arbitrary or unplanned. There should be no connection between the bonus and a prior promise, contract or agreement with the employee.

FYIDid you know
The employee should not expect a promise of payment when receiving a discretionary bonus; it should be somewhat arbitrary or unplanned.

Discretionary vs. nondiscretionary bonus

Unlike with a discretionary bonus, a nondiscretionary bonus requires the employee to meet some qualifications. The employer sets those criteria in advance and informs the employee of how they must meet those requirements to receive the bonus.

Hiring bonuses and performance bonuses are examples of nondiscretionary bonuses. An incentive pay plan is another type of nondiscretionary bonus. An employee qualifies for this bonus when they meet the established performance or productivity goals.

Importance of defining types of bonuses

The Fair Labor Standards Act defines which employees are eligible for overtime pay. Offering employees bonuses could retroactively increase their regular compensation, which may result in the employee earning additional overtime pay. 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.

If an employer gives a nondiscretionary bonus to a nonexempt employee and it increases the employee’s hourly rate, the employer must factor the nondiscretionary bonus into calculating overtime pay calculations 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 amount of the bonus afterward.

FYIDid you know
If the employer pays a year-end bonus to a nonexempt employee, the employer must divide that bonus into the weeks in which the employee earned the bonus to determine additional overtime pay owed to the employee for the bonus period.

Types of discretionary bonuses

Employers may award an employee a discretionary bonus for a variety of reasons, including:

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

Referral bonuses

Employers sometimes award referral bonuses to current employees for recruiting new employees. A referral bonus is discretionary if these 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 spends time soliciting potential employees in their off-hours, involving only friends, relatives, neighbors and acquaintances.

Retention bonuses

Employers sometimes award retention bonuses to employees when there are very specific circumstances (such as a merger or acquisition) or when the company or department needs to complete an important project. Employers award these bonuses to provide continuity when there is a lack of certainty with respect to an employee’s ongoing employment. A retention bonus encourages the employee to remain with the company until a certain date to ensure that they can continue their involvement in organizational priorities.

Holiday bonuses

Employers may award holiday bonuses to employees at the end of the year during annual events and other occasions. The actual bonus could be 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 becomes nondiscretionary if the giving of the bonus meets these criteria:

  • It is certain and clear.
  • It is reasonable and fair.
  • It has become a regular practice over a period of time.
  • It is reasonably expected by employees to continue happening.
  • It has been applied in a consistent manner to employees.

How to create a bonus plan

Employers should keep the bonus structure and process consistent, especially if they have already explained and established how they will calculate and pay out discretionary bonuses. It’s best to simplify the process of calculating discretionary bonuses and overtime pay.

An employer’s discretionary bonus plan should be:

  • Simple: Make the bonus plan simple and 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 in every department should be eligible to receive a bonus, and the level of each bonus should be fair 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. The employer should attach meaning to the bonus to provide the employee with a greater sense of fulfillment. This will provide the employee with a greater sense of earning or deserving the bonus.
  • Material: A bonus should be of sufficient size that the employee appreciates it. A cheap gift or very small financial bonus might insult the employee and decrease their motivation and appreciation of the bonus.

Funding discretionary bonuses

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 the range of amounts that can be allocated to employees after a certain 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 the specific bonus amount by the number of sales the employee makes.
  • 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, divide the total bonus by the total number of hours to determine an hourly rate and multiply this rate by each employee’s number of hours worked.

How to implement discretionary bonuses for employees

Now that you have created your bonus plan, it’s time to put it into action. Follow these steps for a comprehensive rollout of your new policy.

Let employees know about the bonus plan.

If your employees are unaware of your bonus plan, it cannot serve to motivate them. You can let them know in multiple ways, including in a companywide email, an in-person employee meeting, and by including it in your employee newsletter and on your 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. 

Include the bonus plan in the employee handbook.

By adding information about the discretionary bonus plan in your employee handbook, you accomplish two goals: You inform new hires about the bonus program, and you enshrine it into your employee policy documents. If employees forget the details of the bonus program after you have told them about it, they can always get the information by reading the employee handbook.

Train managers on the bonus criteria. 

Since managers will be deciding who will receive the bonuses, or at least giving their input, they need to know what the criteria are for giving the bonuses. Train managers on the requirements and let them know if there is room for their personal judgment in the decision. Some bonuses, such as referral bonuses, are straightforward, while others, such as those for outstanding work, are more subjective. 

TipBottom line
Let managers know that when making decisions about who will receive a bonus, favoritism is frowned on. Choosing favorites for successive bonuses will negatively affect employee morale.

Set up reviews to decide which employees qualify for bonuses.

Because these discretionary bonuses do not have an automatic trigger, employees will need to be reviewed to see if any of them qualify to receive the bonus, and if so, which ones will receive it. These reviews should take place on a regular schedule, either quarterly or monthly.

In any given review period, you may have more than one employee who has met your criteria for the bonus. If the bonus amount is relatively small, you may decide to give all qualifying employees the bonus. However, if it is larger or the bonus is set up with a time period (such as for employee of the month), you will need to narrow it down with the understanding that the second-most-qualified employee will be honored the next time.

Jennifer Dublino contributed to this article.

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Written By: David GargaroSenior Writer & Expert on Business Operations
David Gargaro has over 25 years of hands-on experience in the business arena. In 2018, he penned "How to Run Your Company… into the Ground," drawing insights from his direct involvement in small business operations. His practical guide covers a spectrum of topics, including strategic partnerships, product development, hiring and expansion strategies. Gargaro has also developed toolkits for startup founders, assisting them in navigating the complexities of entrepreneurship. He is a professional speaker as well, addressing audiences on topics such as the customer experience. Additionally, Gargaro's expertise in sales, marketing and financial planning has been featured in publications like Advisors Magazine, Moody's Analytics and VentureBeat.
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