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Updated Jan 04, 2024

Guide to Employee Bonuses

Learn how to understand, implement and structure various types of employee bonuses.

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David Gargaro, Senior Writer & Expert on Business Operations
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Employee compensation involves more than an employee’s initial salary when they join a company. Total compensation can include overtime, on-call pay, special project pay, bonuses, raises, benefits and stock options (or other investment options). For example, some businesses offered bonuses to employees who worked during the COVID-19 pandemic.

Any compensation in excess of an employee’s base salary or hourly wage can be categorized as employee bonuses or bonus pay. We’ll explain the various bonus types and how to implement and structure employee bonuses.

Types of employee bonuses

These are some of the most common types of employee bonuses:

Annual bonus

An annual bonus is awarded to an employee once per year. The bonus amount is typically based on the employee’s annual base salary or a set percentage for the department or position. Most companies assign a target bonus that each employee is eligible to receive at the end of the year. The employer awards the full annual bonus if the employee meets specific goals and the company or department meets its performance goals.

Signing bonus

A signing (or sign-on) bonus is a one-time payment an employer or recruiter pays a new employee. Its purpose is to convince an individual to join a company. Employers use a signing bonus when they’re trying to lure a top employee or executive away from a competitor, outbid another company’s competing offer, or close the gap between the employee’s desired salary and the company’s offered salary. Signing bonuses often come with a contractual requirement that the employee stay with the company for a minimum period.

FYIDid you know
If you're recruiting employees in a specific state or city, you may be obligated to abide by wage transparency laws during the recruitment process.

Discretionary bonus

A discretionary (or spot) bonus is awarded to an employee for various reasons, such as demonstrating exceptional performance or achieving a specific employee performance goal. This bonus is typically given at the whim of the employer or manager to show gratitude for something the employee has done. Discretionary bonuses are usually unexpected by the employee because they are not included in the employment contract. The bonus can be monetary, a gift or some other form of compensation.

Retention bonus

A retention bonus is a reward given to an employee for remaining with the company for a set period. It can be used to encourage high-performing employees to stay with the company amid a competitive job market or to retain a valuable employee who has received a job offer from a competitor. A retention bonus is typically given as a one-time payment in lieu of a raise. 

Referral bonus

A referral bonus is given to reward current employees for helping to attract and recruit new employees. The bonus is typically paid after the new employee joins the company and performs their job duties for some length of time. The referral bonus amount depends on several factors, such as the type of role and how hard it is to fill.

Holiday bonus

A holiday bonus is typically awarded around recognized holidays (such as Christmas and Hanukkah). Its goal is to thank and reward employees who have contributed to the company’s success. A holiday bonus is often tied to the performance of both the overall company and the individual employee. It can often help to boost employee loyalty and create goodwill.

Profit-sharing bonus

A profit-sharing bonus provides employees with a percentage of the company’s profits. The award is calculated using the company’s earnings during a specific period. Employers award this bonus to employees when the company realizes a profit. Some portion of pretax profit is placed into a pool for distribution to eligible employees according to their salary and title. The profit-sharing bonus can comprise cash or stocks.

Commission

A commission is a bonus based on the amount of money or revenue a sales team member earns from facilitating sales. The commission amount is defined in the sales commission structure, which describes how the employer will pay salespeople for each sale. 

These are some of the most common types of commission structures:

  • Base salary plus a specific commission: For example, the commission could be a percentage of sales.
  • Absolute commission: The employee is paid for performing specific activities or meeting specific goals.
  • Relative commission: The employee is paid for meeting a target or quota.
  • Territory volume commission: The employee is paid for sales across a territory, rather than for an individual sale.
  • Straight-line commission: The commission is based on a percentage of the quota.
  • Tiered commission: The commission increases when the person hits higher sales milestones.
Did You Know?Did you know
Bonuses are a job perk that employers extend to boost retention, improve morale and stave off devastating events like the Great Resignation.

What to consider when creating an employee bonus plan

Consider the following factors when you’re developing an employee bonus structure:

  • Business goals: Identify the business goals you’ve set for your organization and the steps required to achieve them. Different goals will require various investment levels. A bonus structure attached to business goals can help you attract and retain top talent.
  • Financial constraints: Bonuses require budget planning. Some companies might have many assets but lack cash reserves; others might have funds tied up in specific projects. Various financial constraints will determine how much you can give in bonuses.
  • Industry trends: Businesses should track industry trends before creating a bonus structure. Companies should attempt to match bonuses their competitors or others in the marketplace offer their employees. Some employers might have to give higher bonuses to keep top employees from searching for work elsewhere in a competitive job market.
  • Employee preferences: Consider asking employees which types of bonuses they prefer. Use their input to choose a bonus structure that will motivate employees to achieve higher performance goals.
  • Desired results: Employers award bonuses to reward employees for various reasons. For example, they may want to improve work quality, finish a crucial project, boost productivity or improve morale. Determine your bonus goals and set expectations for what will happen when you implement a bonus system. Setting specific goals will make it easier to measure your results.

Structuring your employee bonus plan

Follow these strategies to structure your employee bonus plan:

  • Document your bonus plan. Create a written document outlining the employee bonus plan’s details. Give all employees this information so they understand how and why bonuses are given. Provide details on the bonus types in your plan, why they exist and how employees can earn these bonuses, especially if a bonus is tied to a specific outcome.
  • Quantify your bonuses. Base your bonus structure on quantifiable results (excluding discretionary bonuses). Create specific, identifiable bonuses matched to measurable performance standards.
  • Incentivize employees. Creative incentives that connect the bonuses to employees’ individual financial goals. This can motivate and encourage employees to help the company succeed and earn profits while gaining personal financial benefits.
  • Create opportunities for everyone. Structure the bonus so employees at all levels of the organization can earn one. To incentivize employees, make higher bonuses more challenging to achieve.
  • Make bonuses as substantial as possible. If possible, provide legitimate financial rewards to increase motivation. For example, making the bonus a percentage of an employee’s salary or compensation will increase their appreciation. Small bonuses can cause disappointment and thus negate their value.
TipBottom line
Profit-sharing bonuses are part of an employee benefits package. Other financial benefits include stock options and retirement plans.

Individual vs. team bonuses

Bonuses can be given per employee or per team or department.

  • Individual bonuses: Individual bonuses are based on an employee’s achievements or performance. The employee determines, through their efforts and accomplishments, whether they will earn the bonus. If the employee does not meet the set goals, they will either not get a bonus or their bonus will be lower than those of employees who met their goals.
  • Team bonuses: Team and department bonuses are based on group goals. Employees must work together to help the team or department achieve those goals, and they earn bonuses based on their contributions and positions within the group.

Employee bonuses and taxes

Employees must pay taxes on bonuses because they’re considered employee benefits and part of an individual’s wages. Taxes include federal and state income taxes, as well as Social Security and Medicare taxes.

Employers must include bonus pay when calculating federal and state unemployment taxes, the Social Security maximum and the Medicare tax. If the employer pays the employee bonus with their regular wages, they must withhold the federal income tax for the total amount. If the employer pays a separate employee bonus, they should do one of the following:

  • Withhold a flat 22 percent of the bonus for the federal income tax
  • Add the bonus to the employee’s regular pay and withhold the federal income tax based on the total pay

If the employer does not withhold taxes from the employee’s paycheck due to exemptions, the employer must add the bonus to the employee’s paycheck and calculate the withholding based on the total amount.

Tax benefits for employers

Employers receive a business tax deduction for bonus payments to employees. Bonus payments fall under the “payments to employees” category, provided the bonus is for services rendered (i.e., not a gift).

FYIDid you know
Among smaller companies (100 or fewer employees), year-end bonuses are the most common, while larger companies favor cash profit-sharing bonuses.

The best payroll services for managing bonuses

Payroll services can ease the administrative and accounting headaches that often accompany bonuses. The best online payroll companies can include bonuses and commissions in employee paychecks, accommodate discretionary bonuses, deduct the correct payroll taxes and withholding amounts, and even advise you when bonus-triggering events occur. 

Here are some of the best payroll platforms to consider for managing bonuses: 

  • Gusto: Gusto handles payroll and provides numerous human resources tools and features, including recruitment, onboarding and benefits administration. Our detailed Gusto review explains how easy it is to add bonuses and other incentives to employee profiles. 
  • SurePayroll: SurePayroll allows unlimited payroll runs, making it easy to add an extra payroll run for quarterly or year-end bonuses. Our SurePayroll review explains how the company guarantees accurate payroll tax calculations, fixes errors and covers any fines incurred if a calculation is wrong. 
  • ADP Payroll: ADP makes it easy to classify discretionary and nondiscretionary bonuses so your company can reward employees and avoid excessive overtime pay. In our review of ADP Payroll, we explain the vendor’s various service tiers, which allow smaller businesses to pay only for the services they need.

Jennifer Dublino contributed to this article.

author image
David Gargaro, Senior 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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