Finance Guide

What Is Incentive Pay and How Does It Work?

By: Emily Totura
Jul 26, 2021 • 6 min read

What Is Incentive Pay and How Does It Work? Here’s What You Need To Know.

We all work long and hard hours, so it feels good when we’re recognized for our work—and it’s even better when we’re rewarded for it! Companies are aware that pay incentives are a great way to show employees that they value their work, and it also encourages them to work more productively.

What is incentive pay?

Incentive pay is essentially a motivational tool that offers financial compensation based on performance—this is different from being paid your regular hourly wage or base salary. Even if you’ve never heard of the term, chances are, you probably know at least a little bit about incentive pay. This is because performance-based pay, bonuses, and rewards are all considered incentive pay.

incentives pay

How does it work?

Bonuses can be either discretionary or nondiscretionary. This means that bonuses are either paid out when the company thinks is best, or it can be specified in documentation like an employee contract.

When it comes to discretionary bonuses, employers can choose to give out bonus pay when they want. For example, they might decide to give an employee a bonus to commend them for working hard and meeting their targets. At the end of the year, many companies will have an end-of-the-year or holiday bonus. Unless it’s part of a contract, this is considered a discretionary bonus.

Discretionary bonuses are agreed upon by both the employer and employee. They can be based on different criteria, such as attendance. Employees typically receive these payments through their regular pay. This is disclosed in an offer letter, employee personnel file, or contract.

The Fair Labor Standards Act (FLSA)

It’s important to know what the FLSA is because it states that all compensation needs to be included in base pay. This is primarily used for overtime, but sometimes, it can also be used for some bonuses. However, these bonuses might not be included depending on certain criteria:

  • If the employer can decide whether or not to pay the bonus.
  • When the employer can decide the amount.
  • If the bonus isn’t paid on the terms of any agreement.

Keep in mind that the FSLA also exempts some employees from overtime rules if they’re paid a fixed salary—at least $684 each week—or if their main duties are executive or administrative. The FLSA requirements also state that exempt employees can be paid up to 10% of their salary in nondiscretionary incentives.

Different Types of Incentive Pay

There are two types of incentives: casual and structured. Smaller achievements are typically rewarded with casual incentives. Examples of these are non-monetary gifts or a small cash bonus. On the other hand, structured incentives are for larger-scale achievements, and they’re more outlined than causal incentives. Typically, these incentives are part of a pay incentive program, and they’re based on a percentage rate of an achieved sales or production goal.

Examples of Incentive Pay

The two most common examples of incentive pay are bonuses and commission. Here, we’ll break each of them down:

Cash

This is one of the most popular forms of incentive pay. It’s as simple as it sounds, employers will give a financial reward on top of their base pay. There are a few ways that employers can give their staff a cash bonus.

Commission

Some companies will pay commission to employees in sales. It’s beneficial to employers because instead of rushing through meetings and trying to acquire more clients, sales representatives can pay more attention to developing relationships with specific clients—they won’t cut any corners. While it depends on the company, sales representatives that excel can make considerably more than their base salary.

Production-based

Production-based businesses can offer incentives relevant to the amount of product that is made. The purpose of this is to encourage employees to use their time productively so that production increases. Organizations are sometimes hesitant to offer this incentive as employees can become preoccupied with trying to produce the largest number of products, often disregarding quality.

Limitations with this can also arise when sales teams need an effort from everyone to make a sale. Sometimes, everyone doesn’t always contribute equally.

incentives pay

One-off improvements 

Bonuses are offered for one-off improvements and are usually given to non-sales employees. To confirm that these improvements happened, companies must audit this. Why is this relevant? Since these accomplishments aren’t as tangible as meeting sales targets, they can be harder to prove.

Similar to sales, limitations can occur within the team when one or more team members aren’t pulling their weight. Most executives, especially ones that are in senior roles, have contracts that state that the company needs to pay out these bonuses. Usually, these are based on certain targets that are based on revenue. It can also be dependent on other aspects

Performance-related pay

Performance-related pay is awarded when an individual goes above and beyond in their role at the company.

Sales program incentive funds 

Spiff” is an acronym for Sales Program Incentive Funds. It’s a short-term sales program in which the strategy is to award a sales rep a small bonus for each sale that they close. If a product isn’t selling, or if inventory needs to be sold—like a clothing store getting ready for a new season—a company might use a Spiff program. The focus of Spiffs isn’t products, but rather trying to dominating the market by beating competitors’ sales.

Shares

Although it’s a little bit more complex than cash, employers can offer their staff shares. It helps to connect employees to the company, which fosters long-term loyalty. Essentially, employees will give workers the chance to buy shares in the business at the current price later on. If it increases by the time that you use the shares, you made a profit.

Other Incentives

Along with financial rewards, there are other incentives that employers can offer. For example, healthcare or a health club membership, gift cards, paid holidays, or a company car. Again, these untraditional incentives will be unique to your employer/company policy.

smiling man standing between brown concrete buildings at daytime

What is incentive compensation management?

Incentive compensation management is mostly seen within sales, specifically commission. The purpose of this management is to strategically use pay incentives to drive an organization towards success.

Are there any downsides to incentive pay?

While incentive pay has proven to increase employee motivation and productivity, it doesn’t always work. Employees can become more interested in what they need to do to get a pay incentive. This takes away their focus from doing their job. Not only will it affect the employees’ work, but it can also harm the downstream and upstream of the company as a whole.

From an employee standpoint, you might not be right. What does that mean? Well, let’s say you set a target for a certain date, and then everyone on your team also makes it. Incentive pay could also hide bigger issues within the company culture. Basically, companies can offer rewards in return for compliance from employees. It might work in the short run, but it won’t work permanently. It could be negatively affecting the business and create a change in attitude among employees.

Will I always earn incentive pay?

Short answer: No. Long answer: It depends on your company, the department that you’re working in, and the state your job is located in. If your employment is at-will, it means that your employer can fire you without compensation.

Commission pay is a little bit different, and sometimes, it falls under mandatory compensation. For example, the New York State Labor Law says that any commission that is earned is “legally considered wages and must be paid to the salesperson,” regardless of whether or not the person was fired, laid off, or quit. Bonuses can differ depending on your employer’s policy.

incentives pay

When do companies offer incentive pay?

It depends on the company that you’re working for. It also depends on the purpose of offering incentive pay, such as to retain employment or to increase employee morale. Companies that have larger teams often introduce commission programs from the start of employment.

Can you negotiate?

You might be wondering if you can negotiate pay incentives like you would base pay in an interview. The simple answer is yes, but there are still limitations. Negotiating your salary or bonuses is not just about getting more money. It’s also about increasing your perceived value as an employee.

Your employer will measure bonuses quantitatively. Know your objectives before meeting with your employer. Once you feel confident, then you can have a conversation with your manager. You’ll want to make your target a little higher than what you want. Remember, don’t push it, and be respectful.

How to Introduce Incentive Pay

If you’re an employer, the way you introduce incentive pay will have a lasting impact on employees.

Consider your compensation strategy, and ask yourself, “what are my goals?” For example, if you want to increase revenue, your company might introduce new products every couple of months. With this, compensations programs would align to the goals of increasing revenue to motivate sales reps. With reps, it might make more sense to award commission compared to bonuses.

Be realistic because each department, team, and employee is different. Certain metrics might work to evaluate one team but not another. It might make more sense for your team to use sales commission over bonuses. So, make sure that the pay incentive that you choose will integrate well within your team, and make sure that it’s achievable.

Set realistic time frames. Each target is different and will require a certain amount of time and attention level. When you establish your goals, think about a realistic time frame for your employees.

Incentive pay taxes

You’ll get taxed on your incentive pay because, according to the IRS, incentive bonuses are considered to be supplemental income. With this, they’re subject to federal and state taxes. Although they’re subject to income taxes, this doesn’t mean it gets added to your income—you won’t be taxed at your top marginal rate. Instead, bonuses are subjected to federal withholding of 22%.

If you’re given a large bonus (more than $1 million), then you’ll be taxed at a higher rate. Sometimes, you might have other tax liabilities on the income that you’re earning from the bonus. First, there is a 6.2% Social Security tax on your bonus that’s below the $137,000 Social Security cap for the tax year. Secondly, there is also a 1.45% Medicare tax.

incentives pay

Tax Payment 

To pay these taxes, employers have two options. The percentage method is most common because it’s simple. Once issued a bonus from your employer, taxes will be withheld at 22% (or the higher rate if it’s larger than $1 million). Employers use the aggregate method to issue a bond with your regular salary. They will then use your salary to calculate the amount of withholding.

Let’s say you normally withhold 40% of your pay for income taxes, then the amount of withholding on your bonus would be the same at 40%. Paying taxes is inevitable. However, you can use your bonuses wisely so that you’ll be able to reduce how much you’ll owe in taxes when it comes time to pay them. To get a tax break, you can use the money to invest in your 401(k) or IRA.

As you work towards meeting your benchmarks, don’t let pay incentives distract you from doing your job.

More to Explore:

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What is a Work Permit, and How Do I Get One?

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