Although bonus pay isn't required by the Fair Labor Standards Act (FLSA), many businesses choose to pay out bonuses because of the advantages they offer them and their employees. Bonus pay can encourage employees to work harder and meet targets — especially when it's tied to performance. 4 days ago
Giving your employees a bonus can be a celebratory experience. You get to thank them for their hard work and reward them for going above and beyond. But before you get to the best part — handing over the bonus check — you’ve got to make sure you process your bonus payroll correctly.
But if you get to know the key facts about bonus payroll, you’ll be able to manage it in no time at all and reward your incredible employees in a meaningful way.
Homebase makes payroll painless. Onboard employees, track their time, and pay them — all in one place. Learn more
What is bonus pay?
Bonus pay is extra compensation you pay your employees on top of their regular earnings. You can award your employees bonuses to thank them for the contributions they make to your business or motivate them to consistently perform at their best.
When people talk about bonuses, their minds typically jump to those that come at the end of the year. But bonus pay is a very flexible term, so it can refer to any extra amount of money employers give out at any time of year. Bonus pay can also be a recurring payment or a one-off.
It’s also important to recognize that bonuses may make up a substantial portion of your employees’ income. In the US, the average bonus pay for hourly workers is around 5.6% of their salaries, which is over a month’s worth of pay.
Why should you award work bonuses?
Although bonus pay isn’t required by the Fair Labor Standards Act (FLSA), many businesses choose to pay out bonuses because of the advantages they offer them and their employees.
Bonus pay can encourage employees to work harder and meet targets — especially when it’s tied to performance. That means employees are more likely to arrive at work on time, stick to their allotted break times, follow internal policies, and work efficiently. Better yet, employees are more likely to overperform at customer service, which can get you five-star Google reviews and positive word of mouth. So, well-managed bonuses can have a major impact on your business’s overall productivity.
Bonuses also show your employees that you appreciate them and value the work they do. This can affect how much team members enjoy their work and increase how emotionally invested they are in their jobs. In fact, employees who get bonuses are eight times more engaged than those who don’t. And of course, happy, engaged employees will probably stay at your business for longer.
What are the different types of bonuses?
There are many different types of bonus payments, but here are some of the most popular ones:
Holiday pay: A cash gift to celebrate special times of the year. For example, a Christmas bonus.
Stock options: Giving employees shares in your business.
Sales commission: Paying your employees back a percentage of the sales they make. This is usually paid monthly along with regular paychecks.
Signing bonus: Payment for accepting a job with a business. New hires usually have to work for a set period of time to receive this kind of bonus pay.
Retention bonus: A reward for working at a business for an agreed-upon amount of time.
End-of-year bonus: A yearly payment, also known as an annual bonus.
Employee-to-customer referral bonus: A reward for an employee who recommends your business to a customer, which results in a larger customer base and higher sales.
Employee-to-employee referral bonus: Similarly, a reward for an employee who encourages someone to apply for work at your business, which leads to them getting hired.
Spot bonus: A one-off bonus given to an employee for a specific achievement. For example, you might pay someone a little extra for introducing a popular new product to your store.
Performance (reward-based) bonus: An extra payment to thank employees for high performance and hard work.
Performance (goal-based) bonus: An extra payment when specific individuals or your whole team meet previously agreed upon targets.
The two bonus categories (and how to calculate bonus pay)
These different kinds of bonus pay fall into two categories: discretionary and nondiscretionary bonuses.
Discretionary bonuses
Discretionary bonuses are exactly what they sound like — they’re bonuses you make at your own discretion. They’re not in your employees’ contracts and are completely optional. Some examples of discretionary bonuses include cash gifts around the holidays, spot bonuses, and rewards-based performance bonuses.
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So, how do you calculate what to pay each employee? Some businesses decide on a budget and simply divide it by the number of employees they have. But this isn’t always equitable when employees work different hours.
A fairer system is to add up your team’s total hours, divide your bonus by that total, and multiply the number you get by each employee’s number of working hours.
For example, pretend you have a small cafe with three full-time employees and two part-time employees. You’ve budgeted US$5,000 for the total bonus you want to give out. But your full-time staff work 35 hours a week each and your part-time staff only work 10 hours, so it doesn’t seem fair to split it five ways. But using the fair system indicated above, you’d calculate:
Everyone’s total hours: 35 + 35 + 35 + 10 + 10 = 125
The bonus divided by that number: 5000 ÷ 125 = 40
The full-time workers’ hours multiplied by this rate: 40 x 35 = 1400
The part-time workers’ hours multiplied by this rate: 40 x 10 = 400
So instead of giving everyone US$1000 each, you’d give your full-time workers US$1400 each and your part-time workers US$400 each. This is a more accurate reflection of each employee’s contribution to your business and is much less likely to cause resentment.
Nondiscretionary bonuses
Nondiscretionary bonuses are the opposite of discretionary bonuses — they’re baked into employee contracts and aren’t optional. They may include end-of-year bonuses, signing bonuses, sales commissions, and goal-based performance bonuses.
Although you have a legal obligation to pay nondiscretionary bonuses, you can write conditions into your employee contracts. This will protect your business from employees abusing your bonus system. For example, you can stipulate that new hires must work for your company for a minimum of six months before you pay them their referral bonus. That way, you won’t have to give out bonuses for new hires that perform badly or don’t end up sticking around.
Can you calculate nondiscretionary bonuses like discretionary ones? Sadly not. There’s a different set of rules, so you have to calculate nondiscretionary bonuses with other formulas.
When you’re paying one-off nondiscretionary bonuses, you can simply decide on a suitable amount for the situation, as well as your business size and industry. For example, salons might pay US$1000 for each employee referral that stays around for at least six months.
But recurring nondiscretionary bonuses can be trickier to calculate. For instance, end-of-year bonuses are often percentages based on employee tenure, role, and performance. So, you might have these categories:
Tenure Role Sales > 5 years = 120% Management = 120% > 20,000 = 120% > 3 years = 110% Supervisor = 110% > 10,000 = 110% > 1 year = 100% Staff = 100% > 5,000 = 100%
To calculate each employee’s bonus, get their percentage from each column. Then, multiply their average monthly salary by those numbers.
Let’s see how this calculation works in action. Say you have a supervisor who has worked at your cafe for four years and made US$25000 in sales in the past year. They make an average of US$2500 per month. So with the formula and table above, you’d calculate:
Their percentages: Tenure = 110%, role = 110%, and sales = 120%
Their monthly salary multiplied by those percentages: 2500 x 110% x 110% x 120% = 3630
So, the supervisor’s bonus would come to US$3630.
You could cut down on a lot of hard work by simply calculating each employee’s bonus based on the same percentage. But again, this isn’t really a fair strategy and may annoy your more experienced and high-performing employees — those you especially want to keep working for you.
3 ways to handle bonus payroll
You have two main options for taxing and processing a bonus: run a separate bonus payroll or include the bonus in your regular payroll run. These methods are also sometimes referred to as “the percentage method” and “the aggregate method.”
1. Run a separate bonus payroll (the percentage method)
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To use the percentage method of withholding for a bonus, you’ll need to run a separate bonus payroll. That means employees will get a separate paycheck for their bonus pay. You’ll also have to withhold income tax at 22% — the flat supplemental withholding rate for all supplemental pay under $1 million. Of course, the bonus will also be subject to other regular payroll taxes.
The advantage of the percentage method is that it’s easy to calculate as a flat percentage and is therefore less error-prone. And if you’re using a payroll solution like Homebase to calculate and send tax payments, then you’ll spend very little time on payroll processing. Employees may also prefer it if they’re in a tax bracket equal to or higher than 22% because they’d pay less tax than with the aggregate method.
However, if your employee is in a much lower tax bracket, this method could result in over-withholding. They can always claim the money back in their tax refund, but they’d probably prefer to avoid the paperwork and have more control over when they get all their pay. Plus, getting a bonus now rather than later might make a big difference in some employees’ finances. In that case, the aggregate method is a better option.
2. Include a bonus in your regular payroll run (the aggregate method)
When using the aggregate method of withholding, you include the bonus with your employees’ regular wages but denote it. This method is more complicated than the percentage method, but it’s still manageable, especially if you have support from your payroll provider or use payroll software like Homebase.
To calculate taxes with the aggregate method, take the following steps:
Calculate the income tax you need to withhold on the regular pay and bonus combined. Calculate the amount you need to withhold on your employee’s regular wages. Subtract the second value from the first value to get the total tax you have to withhold from the bonus.
Imagine you have an employee whose annual salary is US$12,500, putting them in the 12% tax band. One month, you give them a bonus payment of US$500. Here are the calculations you’d have to make:
The regular pay and bonus pay added: 1040 + 500 = 1540
12% of that total: 1540 x 12% = 184.80
12% of the regular pay: 1040 x 12% = 124.80
The second value subtracted from the first: 184.80 – 124.80 = 60
So, you’d withhold US$60 from that employee’s bonus pay.
3. Lump the bonus in with regular wages
Technically, there’s a third option. You could increase your employee’s regular wages and not denote their bonus. That means you’d withhold taxes on your employee’s combined wages and bonus pay like it was all regular pay.
This might seem like an easier option as it involves less math. However, failing to denote the bonus could cause problems for your business and your employee.
The Internal Revenue Service (IRS) usually treats bonuses as “supplemental wages,” which is why they’re subject to a supplemental withholding rate. And if you fail to report your employees’ supplementary pay, it leads to incorrect tax withholding. That means extra paperwork and stress for you and your employee when you have to fix the mistake later. And even worse, it may damage your employee’s trust in you.
Make sure bonus pay is a celebration, not a disaster
Who doesn’t want to reward their employees for all their hard work? But of course, you want to provide all your valuable team members with bonus pay without punishing yourself.
If you want to take the hassle out of your payroll process so you can celebrate bonus pay with your team, Homebase payroll software can help. Our payroll tool can handle all your payments, calculations, paperwork, and bonus tax rates. And when you sign up, you can onboard employees, track their time, and run payroll all in one place.
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