Types of Compensation: Everything HR Professionals Need to Know
If organizations want to reward their employees fairly, they need to understand different types of compensation and how to create attractive compensation packages for their employees. Let’s dive into different types of compensation employers can offer.
What is compensation?
Compensation refers to any payment given by an employer to an employee during their period of employment. In return, the employee will provide their time, labor, and skills.
This compensation can be in the form of a salary, wage, benefits, bonuses, paid leave, pension funds, and stock options, and more. Compensation is also sometimes referred to as remuneration outside of the U.S. and Canada.
Understanding the different types of compensation is critical to creating an attractive compensation package for your current employees. Not only will this help you retain your top talent, but it will also help you attract new talent to your organization—as long as you set yourself apart from your competition.
Conducting a compensation analysis and creating a solid compensation strategy is the responsibility of HR and compensation & benefits professionals. Where there isn’t a Human Resources team in place, this will usually often fall on the business owner or manager. If this isn’t your area of expertise, using the right compensation metrics can go a long way.
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Suppose you haven’t yet given much thought to your compensation and benefits strategy. In that case, you’re potentially missing out on improving your employees’ overall happiness and engagement, along with your employee retention figures and employer brand.
What are the different types of employee compensation?
Compensation plans vary from country to country. For example, in the US, health benefits often make up a large part of an employee’s compensation and benefits package. Whereas in parts of Europe, parental leave, childcare, and lunch expenses are more common.
There are two main types of compensation:
- Direct compensation (financial)
- Indirect compensation (financial & non-financial)
Everyone involved in creating an employee compensation plan and pay structure must first understand the different types of compensation. This is because it is the organization’s responsibility to explain the compensation plan to all candidates and employees. It is especially important during the hiring process, and performance and salary reviews. With so many different options available within the main two types of compensation, employees can easily become confused.
Let’s explore these types of compensation in more detail.
Direct compensation is a financial (or monetary) form of compensation. Here are the four main types of direct compensation:
Hourly wages are often provided to unskilled, semi-skilled, temporary, part-time, or contract workers in exchange for their time and labor.
Jobs where some employees receive hourly wage include the retail, hospitality, and construction industries.
Employees who receive hourly wages are usually able to earn overtime pay. This pay consists of any additional hours worked outside of their set contract.
When setting your employees’ wages, you need to be compliant with the local minimum wage legislation.
Annual salaries are typically provided to most full-time employees or skilled employees and those who fill management positions. A salary often indicates that the organization has invested in this employee for the long-term future.
Examples of employees who receive a salary include teachers, accountants, doctors, and retail and hospitality managers.
Both hourly wages and salary make up an employee’s base pay or base salary.
Commission is a common form of compensation provided to employees in sales roles. It will usually be based on a predetermined quota or target. The higher the quota reached, the higher the commission will be.
Commission rates are often based on various specified factors, including revenue and profit margins.
Some employees will work on commission only or obtain a salary with commission.
Companies often offer bonuses to employees based on year-end business results or the individual meeting their set goals. Sometimes, the decision is at the manager’s discretion.
Bonuses can be paid annually, quarterly, or even after the completion of each project.
Both commission and bonuses fall under incentive pay, along with piece rate, profit sharing, stock options, and shift differentials.
However, bonuses can also be paid without an employee meeting a particular target. For example, if the business has had a great year and decides to reward everybody. In this case, the bonus would be classified as variable pay.
Tips are also a common form of compensation in people-based industries, particularly hospitality.
Another umbrella of direct compensation is deferred pay which includes savings plans and annuity.
Merit pay is often given to an employee who meets their targets or performs well in their role.
Indirect compensation is still a financial form of compensation since it has a financial value. However, employees do not directly receive it in cash form. That’s why certain types of indirect compensation are viewed as monetary, while others are deemed non-monetary. This often varies between organizations.
Indirect compensation is often known as employee benefits or perks of the job.
Here are some common examples of indirect compensation.
Equity as part of a compensation package essentially means the employee is offered equity (ownership) in the company, either through shares of stock or the option to buy such shares.
An equity package is common at start-up companies. These businesses may be low on cash or funding and need other incentives to attract and retain employees.
This form of compensation entitles employees to purchase a set number of shares at a fixed price after a certain period. This is different from an equity package because the employee will not have any ownership in the company.
Many stock options require employees to work between three to five years before they can access this compensation.
Typical employee benefits usually include health insurance, life insurance, retirement plans, disability insurance, legal insurance, and pet insurance.
Healthcare is a common benefit in the US, as discussed, since it’s expensive to purchase. Whereas, in the UK, healthcare is free on the NHS.
Retirement funds and pension plans are also common benefits that employees look for when considering a new role at a new organization.
A survey found that 48% of job seekers in the US said they would be more likely to apply for a job that came with good benefits. So although the base pay you offer is important, thinking about your overall compensation package is essential.
Non-monetary compensation includes benefits like:
- paid or non-paid time off
- learning and development opportunities
- parental leave
- company cars
- phones or laptops,
- and meals.
A survey by Fractl found American employees value healthcare most as a benefit. Still, additional forms of indirect compensation, including extra vacation time, daycare, and tuition reimbursement, also made the most-wanted list.
Silicon Valley companies offer their employees a wide variety of ever-enticing perks, including concerts, onsite yoga classes, massages, free accommodation stays while on vacation, foosball tables, and catered lunches.
Although some of these forms of compensation seem small or superfluous, they can make a tremendous difference to your employee’s day. This can improve their overall happiness in and outside of the workplace.
It’s important that you offer a variety of benefits that will appeal to different types of people you employ and are looking to hire in the future. For example, if any of your employees have just become new parents or are looking to start or grow a family within the next few years, they will highly value benefits like parental leave and childcare.
In addition, certain forms of compensation can be viewed both as a perk and a disadvantage, depending on the rules you apply to it. For instance, if you provide all employees with a company laptop, are they required to keep this solely for business purposes, or are they free to use it for personal use? Some individuals could view having two laptops as a hassle. Others may not like the idea of the company tracking and monitoring their entire private browsing history. This is why it’s essential to get clear on who your core employees are and what they want before creating a compensation plan.
Once again, there are differences in what counts as non-monetary compensation between organizations.
An employee’s total compensation consists of a compensation package made up of all the applicable types of compensation listed above. The total compensation can (and will) often include different rewards and benefits at different job levels.
A total compensation statement is helpful for employees. They get a clear idea of everything they’re entitled to from the start and the different types of compensation on offer. For example, splitting out base pay, bonuses, and commissions will help employees understand what they are automatically entitled to and what they need to meet targets to earn.
You could arrange the compensation into two different columns: direct compensation and indirect compensation. Or you could go a step further and split the compensation out into different sub-categories within each of those—such as healthcare, a company car, stock options, and a pension fund.
Each new hire should receive a full, clear report of their total compensation and have a manager to approach with any questions. This means that all managers should have at least a basic understanding of the compensation package on offer. They should be able to explain how it works, and answer any questions that arise.
Research has shown that when an organization is progressive and transparent with compensation management, employee engagement rises, turnover falls, and your employer brand gets a boost. Therefore, HR teams must be strategic in the total compensation packages they offer employees and how they present this through all stages of the hiring and employment process.
A basic set of compensation is required by law, so your team must ensure compliance with these ever-changing laws state. A generous compensation package will inevitably help you stand out from your competition and attract the right kind of talent to your organization, in addition to helping you retain your existing employees.
The right compensation package will help you attract and retain talent
Understanding employee benefits and types of compensation and creating attractive compensation packages for all your employees is essential to attracting top talent to your organization and keeping those employees happy.
Many organizations offer similar wages and salaries, so if an employee is choosing between two different job offers, they are likely to compare smaller details included in the compensation plan. An organization that offers small perks like free lunches and extra vacation time is likely to be more appealing than an organization that provides nothing of the sort.
Therefore, your employee compensation plan is integral to helping you build and maintain a strong team. It forms a large part of your employee value proposition.
If you haven’t yet created a compensation package for your employees, there’s no better time than now to begin.