Guide to Employee Bonuses

Types of employee bonuses

These are some of the most common types of employee bonuses:

• Annual bonus
• Signing bonus
• Discretionary bonus
• Retention bonus
• Referral bonus
• Holiday bonus
• Profit-sharing bonus
• Commission

Annual bonus

An annual bonus is awarded to an employee once per year. The bonus amount is typically based on the employee’s annual base salary or a set percentage for the department or position. Most companies assign a target bonus that each employee is eligible to receive at the end of the year. The employer awards the full annual bonus if the employee meets specific goals and the company or department meets its performance goals.

Signing bonus

A signing (or sign-on) bonus is a one-time payment an employer or recruiter pays a new employee. Its purpose is to convince an individual to join a company. Employers use a signing bonus when they’re trying to lure a top employee or executive away from a competitor, outbid another company’s competing offer, or close the gap between the employee’s desired salary and the company’s offered salary. Signing bonuses often come with a contractual requirement that the employee stay with the company for a minimum period.

Discretionary bonus

A discretionary (or spot) bonus is awarded to an employee for various reasons, such as demonstrating exceptional performance or achieving a specific employee performance goal. This bonus is typically given at the whim of the employer or manager to show gratitude for something the employee has done. Discretionary bonuses are usually unexpected by the employee because they are not included in the employment contract. The bonus can be monetary, a gift or some other form of compensation.

Retention bonus

A retention bonus is a reward given to an employee for remaining with the company for a set period. It can be used to encourage high-performing employees to stay with the company amid a competitive job market or to retain a valuable employee who has received a job offer from a competitor. Typically, a retention bonus is given as a one-time payment instead of a raise. 

Referral bonus

A referral bonus is given to reward current employees for helping to attract and recruit new employees. The bonus is typically paid after the new employee joins the company and performs their job duties for some length of time. The referral bonus amount depends on several factors, such as the type of role and how hard it is to fill.

Holiday bonus

A holiday bonus is typically awarded around recognized holidays, such as Christmas and Hanukkah. Its goal is to thank and reward employees who have contributed to the company’s success. A holiday bonus is often tied to the performance of both the overall company and the individual employee. It can often help to boost employee loyalty and create goodwill.

Profit-sharing bonus

A profit-sharing bonus provides employees with a percentage of the company’s profits. The award is calculated using the company’s earnings during a specific period. Employers award this bonus to employees when the company realizes a profit. Some portion of pretax profit is placed into a pool for distribution to eligible employees according to their salary and title. The profit-sharing bonus can comprise cash or stocks.

Commission

A commission is a bonus based on the amount of money or revenue a sales team member earns from facilitating sales. The commission amount is defined in the sales commission structure, which describes how the employer will pay salespeople for each sale. 

These are some of the most common types of commission structures:

• Base salary plus a specific commission: For example, the commission could be a percentage of sales.
• Absolute commission: The employee is paid for performing specific activities or meeting specific goals.
• Relative commission: The employee is paid for meeting a target or quota.
• Territory volume commission: The employee is paid for sales across a territory, rather than for an individual sale.
• Straight-line commission: The commission is based on a percentage of the quota.
• Tiered commission: The commission increases when the person hits higher sales milestones.

What to consider when creating an employee bonus plan

Consider the following factors when you’re developing an employee bonus structure:

• Business goals: Identify the business goals you’ve set for your organization and the steps required to achieve them. Different goals will require various investment levels. A bonus structure attached to business goals can help you attract and retain top talent.
  “Aligning compensation with business goals also helps employees feel more invested in the organization’s performance,” said Marcus Dillon, certified public accountant and president of Dillon Business Advisors. “When incentives are easily calculated by both employees and employers, it provides clarity on the goals being met and how team members can benefit.”
• Financial constraints: Bonuses require assets but lack cash reserves; others might have funds tied up in specific projects. Various financial constraints will determine how much you can give in bonuses.
• Industry trends: Businesses should track industry trends before creating a bonus structure. Companies should attempt to match bonuses their competitors or others in the marketplace offer their employees. Some employers might have to give higher bonuses to keep top employees from searching for work elsewhere in a competitive job market.
  “If you are losing employees and candidates due to paying below market, bonuses can have a real impact,” said Rey Ramirez, co-founder of Thrive HR Consulting. “If the market demands a bonus for a role or industry, not providing the opportunity will make it difficult to attract and retain talent.”
• Employee preferences: Consider asking employees which types of bonuses they prefer. Use their input to choose a bonus structure that will motivate employees to achieve higher performance goals.
• Desired results: Employers award bonuses to reward employees for various reasons. For example, they may want to improve work quality, finish a crucial project, boost productivity or improve morale. Determine your bonus goals and set expectations for what will happen when you implement a bonus system. Setting specific goals will make it easier to measure your results.

Structuring your employee bonus plan

Follow these strategies to structure your employee bonus plan:

• Document your bonus plan: Create a written document outlining the employee bonus plan’s details. Give all employees this information so they understand how and why bonuses are given. Provide details on the bonus types in your plan, why they exist and how employees can earn these bonuses, especially if a bonus is tied to a specific outcome. “Make it easy to understand and avoid using accounting jargon employees may not be familiar with,” advised Ramirez.
• Quantify your bonuses: Base your bonus structure on quantifiable results (excluding discretionary bonuses). Create specific, identifiable bonuses matched to measurable performance standards.
• Incentivize employees: Creative incentives that connect the bonuses to employees’ individual financial goals. This can motivate and encourage employees to help the company succeed and earn profits while gaining personal financial benefits.
• Create opportunities for everyone: Structure the bonus so employees at all levels of the organization can earn one. To incentivize employees, make higher bonuses more challenging to achieve.
• Make bonuses as substantial as possible: If possible, provide legitimate financial rewards to increase motivation. For example, making the bonus a percentage of an employee’s salary or compensation will increase their appreciation. Small bonuses can cause disappointment and thus negate their value.

In addition to these strategies, don’t forget to celebrate bonuses. You might consider holding lunches, team events or one-on-one meetings to acknowledge accomplishments and recognize everyone involved. “Expressing appreciation and highlighting how the collective effort led to the opportunity to share business profitability in the form of a bonus is important,” said Dillon. “I also recommend listing bonuses as a separate line item on pay stubs to highlight the bonus compensation and provide another way to celebrate the achievement.”

Individual vs. team bonuses

Bonuses can be given per employee or per team or department.

• Individual bonuses: Individual bonuses are based on an employee’s achievements or performance. The employee determines, through their efforts and accomplishments, whether they will earn the bonus. If the employee does not meet the set goals, they will either not get a bonus or their bonus will be lower than those of employees who met their goals.
• Team bonuses: Team and department bonuses are based on group goals. Employees must work together to help the team or department achieve those goals, and they earn bonuses based on their contributions and positions within the group.

Whether offering individual or team bonuses, former CEO of Lawn Love Jeremy Yamaguchi said it’s important to understand the impact and perception of each bonus: “You want everyone to feel like they received the fair bonus they deserved and that the system was carefully thought-out.”

Employee bonuses and taxes

Employees must pay taxes on bonuses because they’re considered employee benefits and part of an individual’s wages. Taxes include federal and state income taxes, as well as Social Security and Medicare taxes.

Employers must include bonus pay when calculating federal and state unemployment taxes, the Social Security maximum and the Medicare tax. If the employer pays the employee bonus with their regular wages, they must withhold the federal income tax for the total amount. If the employer pays a separate employee bonus, they should do one of the following:

• Withhold a flat 22 percent of the bonus for the federal income tax
• Add the bonus to the employee’s regular pay and withhold the federal income tax based on the total pay

If the employer does not withhold taxes from the employee’s paycheck due to exemptions, the employer must add the bonus to the employee’s paycheck and calculate the withholding based on the total amount.

Tax benefits for employers

Employers receive a business tax deduction for bonus payments to employees. Bonus payments fall under the “payments to employees” category, provided the bonus is for services rendered, such as not a gift. “Some businesses may prefer to give employees cash or gift cards, but this can negatively impact both parties if discovered by taxing authorities,” explained Dillon. “Properly paying bonuses ensures clarity for all parties regarding total compensation.”

Casey Conway and Jennifer Dublino contributed to this article.