Define Compensation: What It Is, The Different Types of Compensation, And Why It’s So Important—An Employer’s Guide

When it comes to running a successful small business, there are few things as important as compensation. A solid compensation plan will not only help your business become more profitable, but it will also help with employee retention—while a bad compensation plan will send top talent running for the hills (and straight to your competitors).

But what, exactly, is compensation? What role does it play in building, growing, and running a successful business? And how can you develop a compensation plan that serves both your business and your employees?

What Is The Definition Of Compensation?

Compensation is defined as the payments you give to your employees in exchange for their contributions to your business—for example, their time, expertise, knowledge, or skills.

Compensation includes cash payment (like an employee’s base salary or overtime pay) as well as non-cash payments (like the employer contributions you make to an employee’s retirement plan). 

Because small businesses need to hire a variety of employees in order to function, employee compensation is typically one of the largest expenses in running a business—which is why it’s so important to get it right.

Base Pay Versus Total Compensation

Often times, when employers think of compensation, they think of base pay—the hourly wages or salary that they pay their employees.

And while base compensation often makes up a large portion of an employee’s compensation package, generally, it’s not their total compensation—and it’s important to understand that difference.

As mentioned, compensation covers both cash and non-cash payments to employees; any way you compensate your employees would fall under the “compensation” umbrella. So, when you hire an employee, it’s important to consider their total compensation package and how that’s going to impact your bottom line—not just their base salary or wages.

What Are The Different Types Of Compensation?

So, how else might you need to compensate your employees outside of their base pay?

Some of the different types of compensation include:

• Base Pay. When you hire someone, you offer them a base salary or hourly wage—and that base pay generally makes up a good portion of their total compensation.
• Overtime Pay. If an employee is eligible to work overtime, any overtime pay they accrue would also be considered compensation.
• Commissions. Salespeople often work partially or fully on commission; when they make a sale, they get paid a percentage of that sale—and that payment would be considered compensation.
• Bonuses. If you have a bonus structure at your company (whether that’s an annual bonus, a bonus based on company performance, or an employee performance-based bonus or merit pay), that would also be considered part of an employee’s overall compensation.
• Employee Benefits. Employee benefits, including cash benefits (like meal allowances or gym stipends) and non-cash benefits (like retirement plants, health insurance, and vacation time) are part of employee compensation.
• Profit Sharing. If you offer profit sharing, any profit sharing distributions made to your employees would be considered compensation.
• Stock Options. Do you offer stock options to your employees? If so, consider that stock part of their compensation.

When you’re building your employee compensation budget (and determining whether you can afford to hire a new employee, and, if you can, how much you’re going to compensate your new hire), it’s important to look at the entire compensation picture—not just the salary or hourly wage you’re going to include in their offer.

Laws Around Compensation

In addition to keeping your budget and profitability in mind, there are also laws you need to consider when determining employee compensation.

Some of the legal issues you’ll want to keep in mind when setting employee compensation include:

• Minimum Wage. In the United States, the Fair Labor Standards Act (FLSA) sets a federal minimum wage for employees—and, as an employer, you need to comply with the standards and make sure your employee compensation is at least minimum wage. In addition to federal laws, different states and municipalities also have their own minimum wage requirements—so before setting your employee’s hourly wage or salary, make sure you’re in compliance with any applicable minimum wage laws.
• Overtime Pay. Under the FLSA, covered non-exempt employees are entitled to overtime pay (at a rate of at least 1.5 times their regular rate of pay) for any hours worked over 40 in a given workweek.
• Equal Pay. Employers are legally obligated to provide equal employment opportunities. That means you need to provide equal pay to employees—and can’t offer an employee less based on things like gender, race, religion, or disability.
• Workers’ Compensation. Most states require employers to carry workers’ compensation insurance for their employees, which will compensate the employee should they become ill or injured on the job.

How To Develop A Compensation Plan For Your Business

Not sure how to develop a compensation plan that works for your business and your employees? Here are some tips to help you get started.

• Offer competitive wages. It doesn’t matter what your personal compensation philosophy is—if you want to retain top talent, compensating them fairly and competitively needs to be a priority; otherwise, they’re likely to look for a better or more lucrative opportunity. Research compensation plans in your industry and make sure your plan is competitive.
• Reimburse your employees for out-of-pocket expenses. Your employees shouldn’t have to spend their own money in order to work for you. If an employee uses their own funds (for example, if they pay for a course you require as part of their training), make sure to offer reimbursement quickly.
• Be transparent about compensation. No one wants to work for a company that’s secretive about compensation. Be transparent about your compensation plan, including executive compensation, retirement plans, and advancement/salary increase opportunities. The more transparent you are, the more your employees will trust you—and the more likely they’ll be to stay with your company.
• Make sure human resources stays informed on compensation laws. As mentioned, there are laws surrounding compensation, and sometimes those laws change. Make sure your human resources team stays current on compensation laws—and adjusts your compensation plan accordingly. (For example, if your state raises its minimum wage, you may need to increase your team’s pay in order to be compliant with the new laws.)

Use Compensation To Build A Sustainable And Profitable Business

Understanding compensation is an integral part of running a successful and profitable business—and attracting top talent to that business. And now that you understand the ins and outs of employee compensation, you have everything you need to develop a compensation plan that works for you and your team.