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What Is a Discretionary Bonus?

David Gargaro
David Gargaro
Web Development / Project Management at VerdaWorks

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.

Providing bonuses is one way to reward employees' contributions to the company's growth and success. Choosing the right incentive plan for your organization can be difficult, as it can incur unnecessary costs and take time to implement and manage. Choosing the right bonus structure will also help to avoid complications regarding overtime pay and the associated taxes.

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 employer might have a specific reason or no reason for awarding a discretionary bonus to an employee. 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.

FYIFYI: 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.

If the employer pays a year-end bonus to a nonexempt employee, the employer must apportion 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 a discretionary bonus for a variety of reasons, including the following:

  • The employee overcomes a challenging or difficult situation.
  • The employee demonstrates exceptional performance that is not awarded under other specified criteria.
  • The employee goes beyond their usual duties.
  • The employer selects an employee of the month.
  • The employer recognizes the employee's work during the holidays.
  • The employee refers 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 during Christmas, New Year's Eve, 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:

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

How to implement discretionary bonuses for employees

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.

Bottom LineBottom line: A discretionary bonus plan should be simple, fair and timely. The bonus should be meaningful to the employee and sufficient enough that the employee appreciates it.

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.
Image Credit: AndreyPopov / Getty Images
David Gargaro
David Gargaro
business.com Contributing Writer
David Gargaro is a content writer and copy editor with more than 20 years of experience in multiple industries, including publishing, advertising, marketing, finance, and small business. He has written on B2B-focused topics covering business technology, sales, marketing, and insurance. David has a Bachelor of Arts degree in English and Actuarial Science from the University of Toronto. He served as the managing editor of a small publishing company, and self-published a book called How to Run Your Company… Into the Ground.