What Is Retro Pay?

What is retro pay?

Retro pay, short for retroactive pay, is money paid to an employee who was underpaid during a prior pay period. Retro pay compensates the employee for the difference between what they received and what they should have been paid. When the issue is discovered, retro pay is typically calculated and included in the employee’s next paycheck.

The need to provide retro pay is relatively uncommon for small businesses, and conducting regular payroll audits can reduce the likelihood of paycheck inaccuracies. However, when payment mistakes do happen, they should be communicated to the affected employee immediately and fixed promptly. 

“When possible, it’s best to first let the employee know in person when a pay error has been made,” said Karen Oakey, an HR expert at HR Mavericks. “Then, follow up with an email. Take the personal approach first and see if there are any immediate questions.”

When do employers owe retro pay?

Using valuable tools like time and attendance software makes it easier to manage employees’ timekeeping records. But paycheck mistakes can still happen, especially if an employment change slips through the cracks or a complicated payroll situation arises. If those errors lead to underpayment, you’ll need to rectify the situation with retro pay.

“Retro pay can apply to any role in any industry,” Mike Eralie, chief operating officer for global payroll at Safeguard Global, told us. “Where we see it the most is in roles that require careful time tracking that determines differing rates depending on the activity being performed or specifically when the task is being performed.”

Here are a few common scenarios where an employer may need to retroactively pay an employee.

Delayed pay raises

If an employee is given a pay raise, their new salary might not be entered into the payroll system in time for their next paycheck. For example, if payroll processing is already underway when the new salary is agreed upon, the rate change cannot be applied until the next pay period. The organization’s accountant or bookkeeping team would then issue retro pay to ensure the worker is correctly compensated based on the approval date of their new salary.

Additionally, there are some instances where a pay raise may be retroactive. For example, if an employee is due to receive an annual pay increase on July 1, but the amount of the raise isn’t determined until August, the increase they receive might be retroactive to July 1. In that case, the paychecks issued in August would include retro pay to cover the increased salary the team member didn’t receive in July.

Miscalculated earnings

There’s always a chance payroll data mistakes can happen. An employee’s pay rate or total number of hours worked could be entered into the system incorrectly, for instance, resulting in the wrong amount paid. As such, employees should always check their pay stubs to make sure they received the correct amount and notify their leader of any discrepancies so they can be investigated and, if necessary, resolved with retro pay.

Unpaid commissions

Some employees, particularly those who work in sales, earn commissions based on meeting or exceeding specific goals. For example, if a sales representative exceeds their target sales numbers for a quarter, they may be entitled to additional income. But if their commissions aren’t calculated automatically upon reaching those milestones, they could go unpaid, necessitating retro pay.

Shift differentials

If an employee works a shift with a different hourly rate than their usual pay or if they work overtime, their paycheck for that pay period should reflect these circumstances. Shift differentials occur when an employee is paid at a higher rate to work outside their normal business hours, such as a night shift. When a staff member works more than 40 hours in a week, they often qualify to be paid 1.5 times their hourly rate for the overtime. But if they aren’t correctly compensated in those scenarios, retro pay would be warranted.

“Imagine a flight attendant who was called in to cover for an ill co-worker, but now the replacement flight attendant is working a different shift than normal or being assigned to a flight that lands in a location with different allowances,” said Eralie. “Chances are all of that information may not be available in the HR system at the time of payroll cutoff and will need to be corrected for … the next pay period.”

Incorrect pay rates

Some organizations offer staffers different pay rates depending on the job the worker is doing. If an employee holds two or more positions within the organization and earns different pay rates for them, the wrong rate may be submitted. Retro pay can make up for any shortchanging.

Delayed bonuses

Similar to commissions, an employee can earn a bonus during a pay period, but it may take a few pay cycles for it to be recorded in the accounting system. Retro pay would ensure the worker receives what they’re owed.

Back pay vs. retro pay

Back pay is similar to retro pay, and they are often confused with one another. However, there are some distinctions between them, so make sure you understand the differences and don’t use these terms interchangeably.

“Retro pay refers to correcting an underpayment for work already performed, often due to rate adjustments or missed raises,” said Li Han Tan, co-founder of the educational accounting company W.L.P Group & Academy. “Back pay, on the other hand, typically stems from legal obligations, such as settlements or wage disputes, and may cover unpaid wages, benefits or overtime.”

Back pay

Back pay is given to employees who weren’t compensated for their work during a prior pay period. In contrast to retro pay, which is tied to underpayment, back pay is for wages that were missed and never paid to the employee at all. To issue back pay to a worker, you can either run a separate, on-demand payroll or include the missing wages in their next paycheck.

Retro pay

Retro pay is when an employer makes up the difference, or shortfall, between wages the employee should have been paid and the amount they actually received during the pay period. Retro pay corrects underpayment resulting from payroll mistakes and miscalculations, whereas back pay compensates an employee for completely missed wages.

How to calculate retro pay

When asked about the best methods for calculating retro pay, Han explained how high-quality payroll services and software tools can help.

“Employers should use payroll software capable of tracking historical pay rates and integrating with time-tracking systems,” Han said. “Tools like ADP or Gusto streamline retroactive pay calculations by automating rate adjustments. Regular payroll audits can also prevent errors from escalating into retro pay obligations.”

>> Read Next: ADP Review & Gusto Review

Regardless of the payroll program you use, the process for calculating retro pay differs depending on whether the staff member is an hourly or salaried employee. 

Hourly employees

When determining retro pay for an hourly employee, first you need to identify the discrepancy. Once you know the correct pay rate and the right number of hours the employee worked, multiply the differential rate by the hours paid and calculate the gross retroactive pay amount.

“For hourly employees, retro pay calculations must account for variable hours, overtime and shift differentials, which can make the process complex,” Han said.

Because retroactive payments go on the employee’s next paycheck, remember to add the amount owed in retro pay to the amount they are owed for the current pay period. If the total number of hours exceeds 40, you’ll have to decide how to make the payment; overtime pay may be needed.

Salaried employees

Because salaried employees don’t have a set pay rate, it can be tricky to determine their retro pay. First, calculate the difference between the salary they were paid and the salary they should have been paid. Then, verify the number of bill days in the year to get the accurate rate.

“For salaried employees, challenges often arise when prorating changes in salary across pay periods,” Han warned.

Read Related Article: Don’t Want to Cut Employees? Try Cutting Salaries

How does retro pay affect taxes?

Even though it’s a correction to a previous paycheck, any retroactive payment must be taxed, and wages from retro pay are subject to the same tax rates as the employee’s regular wages. 

As retro pay is a type of supplemental pay, you should use the percentage or aggregate method to withhold federal income tax from that supplemental wage. You’ll also need to withhold FICA tax (Social Security and Medicare) and, when applicable, state and local income tax.

Companies should consult their state government about how to calculate state and local income taxes on retro pay. If you issue a separate check instead of adding the retro pay to the employee’s next paycheck, that payment is still subject to the same taxes.

“The key issue when it comes to doing a retro calculation correctly is applying the rates (tax, accumulation rates, etc.) that were applicable at the time the pay should have been calculated,” Eralie said. “Similarly, it is important to understand what other non-direct pay impacting accumulators may need to be adjusted. [For example] in the U.S., how does the retro pay impact 401(k) contributions or the company match? All these areas need to be checked.”

Retro pay done right

Retro pay is crucial for regaining employee trust when errors occur and for compliance with labor laws. Addressing underpayments promptly and accurately shows your commitment to fairness while preventing workplace dissatisfaction. Clear communication and precise recalculations ensure a smooth resolution, whether the issue arises due to an unincorporated pay raise, commission omission or overtime error.

Regular payroll audits and professional payroll services can help prevent these errors and support compliance with tax regulations. By handling retro pay promptly and effectively, you protect your business’s reputation and foster a culture of integrity and transparency.

Amanda Hoffman and Sean Peek contributed to this article. Some source interviews were conducted for a previous version of this article.