Bonuses are a way for employers to recognize and reward employee accomplishments in a monetary form. Bonuses can become an integral part of a company's compensation package and have gained favor as a way of tying pay to performance.

While some bonuses can be entirely gratuitous, there is an element of gift giving in all of them. Employers that award bonuses may receive certain practical and tangible benefits in return. A bonus is seen as an expression of goodwill from employer to employee. Whether it's a singular reward for a significant accomplishment or a holiday gift that all receive, bonuses exemplify a personal touch and may evoke incalculable loyalty and dedication.

Bonuses allow organizations to link employee compensation to performance and allow for increased productivity. They can be used as an incentive to retain top performers and can be used to eliminate or reduce annual salary increases.

Bonuses come in many different forms. They can be express, implied, based on the company's performance in a given period, or based upon an individual's performance. Express bonuses are those that are promised (e.g., you will receive this much); implied bonuses might be reasonably inferred (e.g., if sales goals are met, you might expect to receive a certain percentage of your salary as a bonus). The following types of payments might accurately be described as bonuses.

Performance awards. These can be given for specific, individual, or group achievements and are commonly used to establish incentives for the fulfillment of particular organizational goals. They range from large payments made to high-level executives who have achieved objectives to inexpensive gifts awarded to employees for exceeding defined targets. A common form of bonus program may set several specific objectives (e.g., increasing sales or improving customer service) and tie payments based on a percentage of the employee's compensation to specific performance levels. Management may set objectives and a maximum payout when the plan is first set up and then calculate the employee's bonus based upon their performance within each objective (e.g., reached 75 percent of the first objective, 50 percent of the second objective, etc.).

Gain-sharing systems. A classic gain-sharing plan is a group incentive plan that encourages employees to improve productivity through more efficient use of labor, capital, materials, and energy and then shares the resultant savings between the company and employees according to a formula. These awards typically reflect the margin of profit or savings realized through an individual's or a group's efforts. Although it can be difficult coming up with a fair method of calculating the gain, these types of bonuses offer strong incentives for exemplary team performance. Gain-sharing plans generally strengthen the pay-for-performance link, improve productivity and quality, and provide possible nonlabor savings through employee involvement and cost-cutting ideas. They can improve morale and worker commitment and loyalty to the organization, and after its initial rollout, may reduce employee turnover.

Traditional gain-sharing has proven very successful primarily in manufacturing companies where large production units handle work of a highly repetitive nature. Work environments where components of work and their associated costs are relatively easy to compute and standardize are prime candidates for traditional gain-sharing. Gain-sharing has been in effect in one form or another since the 1930s. Interest declined during the 1950s and 1960s as the economy boomed and companies enjoyed unparalleled growth. During the late 1970s and 1980s, gain-sharing enjoyed somewhat of a revival as companies sought ways to increase worker productivity and to link compensation costs to a company's fate. Then in the 1990s, we saw full-scale implementation of many new varieties of gain-sharing, particularly in the service sector-banks, insurance companies, and government. While it may not be right for every company, the conditions favorable to gain-sharing are worth exploring. Many companies start out with gain-sharing in one or two units and then expand it to other areas or change the plan to include more employees. If appropriate, gain-sharing is easily adapted, and it provides an excellent group-based performance and pay plan that sends the right messages about team goal-oriented behavior. Simple in basic concept, gain-sharing is nevertheless a strategy that requires careful and innovative thought and many hours of design and process work. A good fit with an organization's culture, value system, and management style is critical to its success.

Profit-sharing. A profit-sharing plan is a group incentive plan that includes all employees in an organization and that focuses on overall business unit profit or a similar bottom-line financial goal. Profit-sharing plans provide a financial safeguard for funding by ensuring that an overall business unit profit level is achieved before any payouts are made. They also provide an opportunity to train employees on financial measures and the operational business factors that affect those measures. Generally, these payments are distributed to all employees having the requisite seniority, not just to particular work groups. These tend to be less directly related to performance. Profit-sharing plans are self-funded, so they are low risk for the company, and can be used to supplement company retirement contributions. They can be linked to company objectives other than to profit and are easy to integrate with suggestion plans and other reward and recognition systems.

Straight profit-sharing plans have been around for a long time and are the most prevalent form of profit-sharing among companies that use this type of group incentive. Under a straight profit-sharing plan, all employees are eligible and, generally, an award pool is generated from the first dollar of profit. Some companies prorate awards if employees have been with the company fewer than three years. After that cutoff, they receive full credit in the plan. Generally, all employees share equally as a percentage of their base pay. An equal-percentage distribution under the plan would divide the total fund by total salaries. The resulting quotient would be multiplied against each employee's base salary to determine individual payouts. Some companies base the plan award on the level of the employee's pay or organization level. A distribution based on level in the organization would establish an employee participation rate based on that level. For example, the employee's job class, or salary grade, would determine what percentage of the profit pool that employee earned. Significant variations exist in the ways that companies address the timing of straight profit-sharing payouts. Many companies prefer to pay once a year because this strategy smoothes performance cycles and is easier to administer. However, it also decreases motivational impact because the length of the performance period is so long. Other companies pay quarterly, or even monthly, with semiannual distributions to "true-up" payouts to real profits. Some companies address adjustment issues by reserving a portion of monthly or quarterly payouts to avoid overpaying based on year-end profits.

Unlike a straight profit-sharing plan that funds from the first dollar of profit, a hurdle-rate profit-sharing plan establishes a minimum-profit threshold and then shares the gain with employees when the threshold is exceeded. Gain, or profit improvement, is what the plan seeks. In this way, hurdle-rate profit-sharing plans are similar to gain-sharing plans. The threshold is a predetermined level of profits, or some other financial return measure, rather than productivity baseline, as in gain-sharing. Where the threshold level of profit is set for plan purposes is a management decision and is a function of the plan's design, objectives, compensation strategy, and affordability. Various considerations must be taken into account when establishing the threshold level. A company that wants to send a strong performance message to employees may freeze current salaries and fund pay "raises" from its hurdle-rate profit-sharing plan. In this case, a fairly low threshold—say 5 percent return on sales (ROS)—may be set. On the other hand, a company that pays at or above the market in base pay may set a high profit threshold—say, 10 percent ROS. The higher the threshold, the lower the risk to the company, but care has to be taken that the goal is achievable. If it is not, the company could run the risk of announcing a new plan that it fails to fund, a situation that will turn employees into unbelievers. Generally, the award threshold is the level of profits (or return) that management expects based on environmental scans, forecasts, and the business planning process. Thus, the threshold reflects realistic expectations for what the company hopes to achieve, and the sharing is from truly "excess" profits, attributable to better-than-anticipated results. Some of these plans begin to fund below full plan achievement—for example, at 90 percent of plan—to reflect the difficulty in accurately forecasting and to account for the fact that goals in the business plan may already be "stretch" goals. Other plans set thresholds at a minimum return to the company and fund much sooner. This approach would be tied to a competitive pay strategy in order to link management interest with company fortunes and would be more applicable to management- and executive-level employees.

Another approach to profit-sharing is the goal-driven profit-sharing plan. In a goal-driven profit-sharing plan, profits are used to establish an incentive opportunity, but employees also must earn that opportunity based on achieving other goals. These other goals are broad corporate goals, rather than unit operational goals, which are used to highlight and focus all employees on the important behaviors for business success. Usually, goal-driven profit-sharing plans are combined with a hurdle-rate approach, with or without pay at risk, to communicate the importance of these other drivers of profit. For example, a company could fund an award pool based on 15 percent of incremental profits over business plan targets. If the excess profit equals $1 million, the incentive opportunity equals $150,000; however, the entire $150,000 is not automatically distributed to employees, as it would be under a hurdle-rate profit-sharing plan. At least a portion of that profit pool must be earned by the employees' achieving other performance goals, such as cost control and customer service, or quality. One advantage of a goal-driven profit-sharing plan is that, compared to objective-based plans, it reduces risk to the company. The fund does not earn for attaining the other objectives until designated profit thresholds have been achieved. Another advantage is that goal-driven plans stress the importance of other goals for company success and, in this way, provide a forum for talking about what employees can do to achieve them. For these reasons, goal-driven profit-sharing plans commonly are used by companies to communicate their important business results.

Sign-on bonuses. Many employers pay sign-on bonuses to attract needed workers, especially hot-skills workers. Sign-on bonuses can offset demands for higher starting salaries and thus leave the company's base compensation program intact. In some industries and professions, employers are forced to pay bonuses to compete for workers. Sign-on bonuses also can induce workers to relocate to less desirable parts of the country. They can be effective with college graduates as part of an attractive package that beats competitors' offers. They are often used in information technology (IT) jobs to persuade workers to change jobs, career tracks, or even industries. The disadvantages of sign-on bonuses is that they may be unfair to workers already at the company, must be implemented with care to avoid legal challenges, and could be a bad investment if the employee leaves soon after hired. Bonuses sometimes are preferable to adjusting the company's salary scales to meet the demands of one hot-skills group, such as IT workers. Typically, these bonuses are cash or stock paid in a lump sum or prorated over the first year of employment.

While sign-on bonuses may sway workers who could join a competitor in this extremely tight labor market to sign on with the employer who gives the bonus, sign-on bonuses aren't a panacea for attracting workers with the right skills. In fact, they often cause as many problems as they solve. Sign-on bonuses can be like a red flag to a bull for workers who are already discontented. Discontent about salary or wages, other perquisites, and even work assignments may be further inflamed when new hires receive bonuses. In an organization with a well-established grade structure where internal equity is an issue of faith, sign-on bonuses for new hires who need to be shown the ropes by employees already on board can help push discontented workers to greater discontent and sometimes even out the door. In a situation where sign-on bonuses are paid to attract workers to special areas of the country or special work shifts, employees who would like to relocate or work different hours may feel the practice is unjust. When sign-on bonuses are paid for technology workers who also receive greater flexibility in terms of hours they can work, telecommuting, and other perquisites that coworkers in other parts of the company do not enjoy, the employer can unwittingly cause even more resentment against both its management approach and the new hires. Even if sign-on bonuses are not announced, the employer's practices usually become public knowledge through gossip. And sign-on bonuses, while they may help with attracting employees, do very little to address the problem of retention.

Sales team incentives. Sales team incentives generally support market strategy and business objectives, while encouraging the sales force to grow new accounts and support existing accounts. Incentives promote the entire sales force working together and encourage cross-selling. Traditionally, sales compensation and executive compensation have been more complex than pay programs for other employees because both executives and the sales force have the power to affect the results of the corporation in ways that other groups may not have had. With more emphasis on complicated variable pay programs for front line employees, that may be changing. However, pay at risk generally is more acceptable and understood for sales representatives than for other employees.

The sales compensation program should be linked directly to the company's marketing strategy to control outcomes critical to the company. As the marketing strategies of individual companies are unique, so are the best sales compensation programs. Sales compensation should be adjusted periodically to support new marketing plans as the company's product mix or product life cycles change. One of the advantages of an incentive program for sales representatives is that the company can design it to support the marketing strategy and change it as the strategy changes.

The most important design features in a sales compensation program are the pay level (how much) and pay mix (proportion of incentive pay to base pay). Pay levels generally will reflect industry practices, but the pay mix should be designed to meet the marketing strategy of the company. The degree of risk in the incentive program has to be balanced with the possibility to earn; the higher the risk, the more the sales representative should be able to earn by accomplishing the company's strategic objectives as they relate to sales.

The company that has a sales representative on straight salary is engendering loyalty to that company, and the sales force's actions are easier to control. For example, salespeople are more willing to engage in nonselling activities such as customer service. This type of approach is most appropriate when the sales force's main job is to service existing accounts or generate goodwill for the company. However, straight salary makes it more difficult to motivate employees to sell new accounts and it may lose the company its top performers, who move to other organizations where both the risk and income potential are greater. On the other hand, a straight commission pay program will generate high volume sales, but volume may not be the company's only concern. If the sales force is paid on straight commission, it will be more difficult to get them to perform other functions that may be necessary for the company's marketing strategy, such as maintaining accounts through good customer service, working with other sales representatives to generate cross-functional selling opportunities, and generating goodwill with customers.

A combination pay program that recognizes sales representatives both for selling and for maintaining accounts is often the best program. This program can be created by mixing incentives while at the same time offering some economic security for the sales force with a base pay program. The base pay program makes it easier for the company to maintain loyal and knowledgeable sales representatives. Incentive pay for things other than pure volume of sales allows the company to exert some control to accomplish the functions other than generating new accounts that are necessary and can support targeted marketing goals.

Some bonuses are targeted to achievements that are not directly related to job performance and are considered to be awards. The following illustrate some of the more common awards for accomplishments in the workplace.

Attendance awards. These awards go to employees with outstanding attendance records and should be designed to encourage consistent attendance. For instance, employers can set up a program to reward perfect attendance over a specific period of time. Generally, the awards are small and may come in the form of a gift certificate, small cash reward, or extra privilege. Specific guidelines should be established to avoid confusion over who qualifies. For example, does perfect attendance include just unused sick time, or does it include no latenesses as well? How long will the time frame be? A reasonable amount of time should be used so that the award is not unattainable. Anywhere between 3 to 6 months is usually considered reasonable. It is always a good idea to publish the names in a company newsletter or post them in a prominent place for all to see.

Recognition awards. Employees often go above and beyond the call of duty by assisting another individual or department, working long hours, or doing something that stands out as exemplary. Recognition awards are a chance for employees (and management) to recognize their colleagues' achievements. As with attendance awards, you should publish or post the employee(s) names to recognize their efforts and inspire other employees. In order to ensure fairness, it is a good idea to have a committee of employees, and not management, decide who receives an award if every nomination is not recognized.

Referral bonuses. Employers wishing to take advantage of an employee's personal contacts can make cash awards in exchange for referring business to the employer or for new hires introduced to the organization by current employees. Many referral bonuses contain a stipulation that the new employee must be employed for a specific amount of time (generally 3 to 6 months) before the bonus is paid out.

Safety awards. Many employers have found that safety awards are a useful incentive in motivating employees to work safely. As with attendance-type bonuses, these awards usually recognize flawless performance over some specified period.

Suggestion awards. These are sometimes promised in the form of a percentage of the savings or profit realized as a result of the suggestion. However, it is a good idea to recognize suggestions in some way because it promotes employee participation and interest in your company's objectives.

Employers have been held legally responsible for the payment of bonuses expressly promised to employees as incentives. Once the worker has satisfied whatever criteria the employer has established to qualify for the bonus, courts will typically order the employer to pay. Bonuses that are completely discretionary are not usually viewed as implied contracts, but those offered to induce people to achieve some desired goal are likely to be held enforceable. One way to avoid liability is to declare publicly (and often) that bonuses are awarded entirely at the discretion of management, are not intended to be binding on the company, and may be withdrawn at any time.

Employers have been ordered to pay bonuses when they offer smaller salaries with large bonuses. In general, the larger the bonus is, the more it will be considered a part of the employee's total compensation package instead of gratuitous.

Inclusion in overtime. Under the federal FLSA, bonus payments are divided into discretionary and nondiscretionary types (29 USC 207; 29 CFR 778.211). Nondiscretionary bonuses are included in an employee’s regular rate of pay for the purpose of determining overtime, while discretionary bonuses are not included in an employee’s regular rate of pay to determine overtime.

Bonuses are discretionary if:

Bonuses are nondiscretionary if the employer promises, contracts, or agrees to pay a bonus to the employee. Nondiscretionary bonuses include:

Calculation. If a bonus is paid over one weekly period the calculation is simple. For example, an employee who works a 45-hour week at $10 per hour, in a week with no bonus, earns 5 hours of overtime at $15 per hour and the week's total pay is $475 ($400 regular pay and $75 overtime). In a week with a production bonus, the employee's regular rate of pay (for purposes of calculating overtime compensation) is determined by adding the pay for all hours worked at the nonovertime rate plus the bonus and dividing this sum by the total hours worked. Thus, if a $45 production bonus is paid, the regular hourly rate for the week rises by $1 an hour to $11 per hour (45 hours times $10 per hour plus $45, which equals $495 all divided by 45 hours; the overtime rate increases to $16.50 per hour; and the week's total pay is $527.50 ($400 regular pay for 40 hours work, plus $45 bonus, plus $82.50 overtime pay for 5 hours of overtime work).

If the bonus is attributed to a period longer than a workweek, the bonus may be disregarded in computing the regular rate of pay until the amount of the bonus is determined. Until that time, any overtime is calculated and paid based on the regular rate of pay, exclusive of the bonus. When the amount of the bonus is set, it must be apportioned back over the workweeks of the period during which it was earned. An additional amount of compensation must then be paid for each workweek during the period in which the employee worked overtime. The amount of additional pay is equal to one-half the hourly rate of pay allocable to the bonus for that week multiplied by the number of overtime hours worked in that week. For example, if the employee described above is paid a $400 bonus for a 10-week period during which the employee twice worked 45-hour weeks, $40 of the bonus is attributed to each week. The hourly rate allocable to the bonus is $1, and the employee must be paid an additional $2.50 for each of the weeks in which the employee worked 45 hours (1/2 times $1.00 times 5 hours).

Exceptions. The FLSA provides for several narrow exemptions from the requirement that bonuses be included in an employee's regular rate of pay. The onus is on the employer to prove that a payment meets one of the exemption requirements. The exemptions include:

Bonuses and the salary threshold for overtime exemption. The required minimum salary is $684 per week ($35,568 per year). Employers may use nondiscretionary bonuses and incentive payments (including commissions) that are paid annually or more frequently to satisfy up to 10 percent of the standard salary level. If an employee does not earn enough in nondiscretionary bonus or incentive payments in a given year (52-week period) to retain their exempt status, the Department of Labor (DOL) will permit the employer to make a catch-up payment within one pay period at the end of the 52-week period. This payment may be up to 10 percent of the total standard salary level for the preceding 52-week period. This type of catch-up payment will count only toward the prior year’s salary amount and not toward the salary amount in the year in which it is paid.

The 2009 final FMLA regulations state that employees on FMLA leave are not entitled to any bonus or payment, whether it is discretionary or nondiscretionary, when the bonus or other payment is based on the achievement of a specified goal such as hours worked, products sold, or perfect attendance, even though the employee has not met the goal due to FMLA leave. Employers, however, may deny such payment only if employees on an equivalent leave status (non-FMLA leave) are also denied bonus and incentive payments. Attendance awards are predicated on the achievement of a specified job-related performance goal, and therefore may be denied based on FMLA absences. Bonuses that are not premised on the achievement of a goal, such as a holiday bonus given to all employees, may not be denied to an employee because that employee took FMLA leave.

Bonuses paid in consideration for services rendered are almost always taxable wages subject to income tax withholding, FICA, and FUTA. These include production, incentive, and nondeferred profit sharing bonuses. Most states require that all forms of remuneration, including bonuses, be treated as wages when figuring the amount of gross payroll for unemployment compensation tax purposes. Noncash gifts of limited value such as holiday turkeys, however, are excluded from income and employment tax coverage.

The Internal Revenue Service has also ruled that bonuses paid to employees for signing or ratifying an employment contract are considered wages subject to FICA, FUTA, and income tax withholding. In addition, a bonus paid to an employee for the cancellation of an employment contract is also considered wages subject to employment taxes and income tax withholding.

Business expense. Bonuses are generally deductible by the employer as ordinary business expenses. To qualify for the deduction, certain requirements must be satisfied. Consult your tax expert or contact the nearest office of the IRS for information on the tax ramifications of your bonus plan.

Gift cards and gift certificates. If an employer gives its employees $35 gift cards--for example, to the grocery store or a shopping mall--the gift will be treated as income and is subject to payroll taxes and withholding, along with the rest of the employees' income. Many employers are in violation of this rule, especially around the holidays, because they assume the gift falls under the de minimis rule. De minimis fringe benefits are not taxable, because they are not considered cash. For example, if a company gives its employees a coupon specifically for a free turkey or a ham at a particular store during the holiday season, this falls under the de minimis rule and is not taxable. Gift certificates that can be used like cash do not fall under the de minimis exception. If the employer gives its employees a $25 gift card to the same store, but not specifically for a turkey or ham, the gift card is taxable as income.

Executive bonuses are often divided into short-term and long-term incentives. Generally, short-term incentives are realized within a year's time. Anything over a year is usually considered a long-term incentive.

Short-term bonuses. Short-term incentives, such as annual bonuses and incentive payments, provide great motivation for executives. Depending on where a company is in the growth cycle and a company's need to invest cash back into the business, short-term incentives can either be cash payouts or deferred compensation. In start-up companies, short-term incentives should not be tied to cash flow or income, because the business is unstable and cash flow might not be attained for a few years. Instead, short-term incentives should reflect an increasing customer base and production goals. More mature companies with a constant measurable cash flow can tie their short-term incentive plans to cash flow and profits.

There are some disadvantages to short-term incentive programs. It is important that companies do not set short-term bonuses so high that an executive loses perspective on the long-term vision and goals of the company, focusing only on meeting the goals of the present year in order to obtain the bonus. Short-term bonuses must be set at a reasonable level so that executives strive for short-term and long-term success. In addition, short term incentives, paid out within a year's time, do not provide the executive with a reason to stay with the company for the long term.

Long-term bonuses. Long-term bonuses are a very important part of the total compensation package, because they encourage executives to remain with the company for the long term and require them to focus on the long-term business and financial success of the company in order to realize their total compensation. For executives, long-term compensation is generally a larger part of the total compensation package than base salary or short-term incentives. There are a variety of forms of long-term compensation, including:

A well-functioning bonus program can yield increased productivity, improved morale, a safer workplace, and numerous other benefits. To get the most out of any bonus plan, consider how it is worded, implemented, monitored, and reviewed. Consider the following practice tips: