Offering employees bonuses is a good workplace incentive and retention tool, but there are many things you should know before implementing a bonus structure.
Employee compensation involves more than the initial salary an employee receives when they join a company. One's total compensation can include overtime, on-call pay, special project pay, bonuses, raises, benefits, and stock options (or other investment options). More recently, some businesses offered bonuses to employees who worked during the COVID-19 pandemic. Any compensation that is in excess of an employee's base salary or hourly wage can be categorized as employee bonuses or bonus pay.
Types of employee bonuses
The most common types of employee bonuses are:
- An annual bonus
- A signing bonus
- A discretionary bonus
- A retention bonus
- A referral bonus
- A holiday bonus
- A profit-sharing 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 to each employee that they are 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.
A signing (or sign-on) bonus is a one-time payment that an employer or recruiter pays to a new employee. Its purpose is to convince an individual to join a company. Employers use a signing bonus to lure a top employee or executive away from a competitor, outbid other companies' competing offers, or to 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 amount of time.
A discretionary (or spot) bonus is awarded to an employee for a variety of reasons, such as demonstrating exceptional performance or achieving a specific 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 typically unexpected from the employee's perspective, as they are not included in the employment contract. The bonus can be monetary, a gift or some other form of compensation.
A retention bonus is a reward given to an employee for remaining with the company for a set period of time. It can be used to encourage high-performing employees to stay with the company during a competitive job market or if a valuable employee has received a job offer from a competitor. A retention bonus is typically given as a one-time payment in lieu of a raise.
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 amount of the referral bonus depends on a number of factors (e.g., type of role, difficulty related to filling the role, etc.).
A holiday bonus is typically awarded around recognized holidays (e.g., Christmas, Hanukkah, etc.). Its goal is to thank and reward employees who have contributed to the company's success. The holiday bonus is often tied to overall company performance and individual employee performance.
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 of time. Employers award this bonus to employees when the company realizes a profit. Some portion of pretax profits 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.
A commission is a bonus based on the amount of money or revenue that a salesperson 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. The most common types of commission structures include the following:
- The base salary plus a specific commission (e.g., 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 versus an individual sale.)
- Straight-line commission (The commission is based on a percentage of quota.)
- Tiered commission (Commissions increase when the person hits higher sales milestones.)
How to determine your employee bonus structure
Consider the following factors when creating an employee bonus structure:
Business goals. Identify the goals for your business and the steps required to achieve those goals. Different goals will require different levels of investment. These goals will require some type of bonus structure to attract and retain top talent.
Financial constraints. Every company has a limited budget for performing different activities. Your budget will determine the bonuses that can be given to employees. Some companies might have a lot of assets but lack cash reserves; other companies might have funds tied up in specific projects. Various financial constraints will determine how much can be given in bonuses.
Industry trends. Companies should attempt to match what their competitors or what others in the marketplace are offering with their employee bonuses. 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 seeking input from employees as to the bonuses that matter to them. Use that input to choose a bonus structure that will motivate and appeal to your employees.
- Desired results. Employers award bonuses to reward employees for doing good work and to motivate them to improve. They should have a goal in mind with bonuses and set expectations for what will happen when the bonus plan is set. Setting specific goals will make it easier to measure the results of giving bonuses to improve employee performance.
Structuring your employee bonus plan
Follow these strategies to structure an employee bonus plan:
- Create a written document that defines the details of the employee bonus plan. Provide all employees with this information so they understand how and why bonuses are given.
- Base the bonus on quantifiable results (excluding discretionary bonuses). Create specific, identifiable bonuses that are matched to measurable performance standards.
- Creative incentives that connect the bonuses to employees' individual financial goals. This can motivate employees to work toward achieving their own interests. It can also encourage employees to help the company succeed and earn profits, which financially benefits them in return.
- Provide specific details on what bonus is being given, the reason for the bonus, and what employees must do to earn the bonus. Tie the bonus to specific outcomes and actions so employees know why they are putting in the effort to receive the bonus.
- Structure the bonus so all employees have a legitimate opportunity to earn a bonus at the lowest level. Make higher bonuses more difficult to achieve to incentivize employees to try harder to achieve more bonuses.
- Provide legitimate financial rewards to increase motivation. Making the bonus a percentage of the employee's salary or compensation will increase appreciation of the bonus. Giving small or inexpensive bonuses can cause disappointment and negate the value of providing bonuses.
Individual versus team bonuses
Bonuses can be given per employee or per team/department:
- Employee bonuses are based on each employee's individual achievements or performance. The employee determines (through their effort 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 other employees who met their goals.
- Team and department bonuses are based on the goals set for the entire group. Employees must work together to help the team or department achieve those goals and earn bonuses based on their contributions and positions within the group.
Employee bonuses and taxes
Employees must pay taxes on bonuses, which are considered benefits and part of an individual's wages. This includes federal and state income taxes, as well as Social Security and Medicare taxes.
Employers must include bonus pay when calculating unemployment taxes, the Social Security maximum and 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% 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, they must add the bonus to the employee's check and calculate the withholding based on the total amount.
Tax benefit for employers
Employers also receive a business tax deduction for bonus payments to employees. Bonus payments fall under the category of payments to employees, provided that the bonus is for services rendered (i.e., not a gift).