What is Compensation? – Definition, Importance, Types, FAQs & Plan

What is Compensation

Compensation is one of the leading expenses for any small business. Before we learn the importance and types of compensation, we’ll learn what is compensation?

Definition of Compensation

Compensation is the remuneration awarded to an employee in exchange for their services or individual contributions to your business. The contributions can be their time, knowledge, skills, abilities and commitment to your company or a project.

In simpler words, compensation is the money received by an employee from an employer as a salary or wages.


Types of Compensation

Compensation doesn’t mean only paycheck, although that’s part of it. Compensation comprises of a number of different elements that may be cash and non-cash payments.

Here’s a list of some of the most common and commonly overlooked types of compensation:

  • Base pay (hourly or salary wages)
  • Commissions
  • Overtime Pay, shift differentials and longevity pay
  • Bonus
  • Profit Sharing distributions
  • Merit Pay or recognition
  • Incentive plan or achievement award
  • Tip income
  • Benefits including Dental, insurance, medical, vacation, leaves, retirement, etc.
  • Stock options
  • Travel/Meal/Housing Allowance
  • Child care and tuition assistance
  • Gym memberships and free lunches
  • Employee assistance programs that provide counseling, legal advice, and other services.
  • Health and wellness benefits
  • Other non-cash benefits

Importance of Compensation

Compensation is one of the most important aspects of running a business that can make or break a business. Having a good compensation plan can help organizations to flourish and compete in their respective markets.

Some of the benefits of providing the right compensation package to your employees are:

  • Attracts top talent
  • Increases employee motivation at the workplace
  • Boosts employee loyalty
  • Increases productivity and profitability
  • Improves job satisfaction and employee engagement
  • Helps in retaining top employee
  • Helps stay in compliance with the Federal and State government agencies

Difference between Base Pay and Total Compensation

Base pay is just one part of your employees’ total compensation and defined as the initial pay received by an employee before taxes and other deduction.

Bonuses, overtime, tips, commissions, and other types of compensation mentioned above are not part of base pay but come under total compensation.


How to Create a Compensation Plan for Your Business

Having an appealing compensation plan for your organization will help in attracting and retaining the top talent. Developing a compensation plan isn’t a simple task but following these steps can help you make your workplace happier resulting in business growth.

1. Compensation Philosophy

Start by developing a compensation philosophy that suits the vision and mission of your business. It should include base pay, commissions, bonuses, tips, incentives, overtime, and other compensations you want to offer.

If you are just starting out and learning how to do payroll for your business, then write down the job titles and job descriptions for all the positions you think are essential for your business.

2. Competitor Research

Research your competitors how much compensation they are offering to similar positions. You can use Glassdoor, PayScale or similar websites to get the information on salary/wage comparison and salary surveys in your city or state. Before you move on to the next step, at least have a ballpark figure of the budget.

3. Salary or Wage

Now it’s time to set a base salary level or hourly pay rate for each position with the information or data you have in your hand from your earlier research. Ensure the salaries/wages should be competitive in your city/state and industry. Take sound advice from HR professionals when deciding whether to pay employees hourly or with an annual salary.

4. Annual Pay Raise

Employees are an integral part of your business; Investing in them will increase productivity and profitability. Having a plan for their annual pay raise and executing it will surely increase the loyalty and performance of your employees.

5. Performance-Based Plan

Create an incentive or performance-based plan for top talent to motivate other employees to improve and increase their performance. Else, you can also offer periodic pay raises.

6. Payroll Software

It’s time to choose payroll software that can help you successfully implement your compensation plan.


Compensation: Laws & Regulations

There are certain rules and regulations that govern how employers handle compensation and they are governed by many local, state, and federal agencies.

Fair Labor Standards Act (FLSA)

Commonly referred to as the Wage and Hour Law, the Act regulates employee status, overtime eligibility, overtime pay, child labor, minimum wages, record keeping, and other administrative concerns.

Equal Pay Act (EPA)

Prohibits wage differential based on sex.

Title VII of the Civil Rights Action of 1964

Prohibits employers from discriminating on the basis of race, color, sex, religion or national origin. The law applies to federal, state and local employers.

Minimum Wage

The federal minimum wage provisions are contained in the Fair Labor Standards Act (FLSA).

You can read more compensation legislation here.

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