What Is Variable Pay and When Should You Use It?

As you might expect, pay is the most important factor for job candidates—64% of job seekers rank it as the no. 1 reason for taking a new job. And so, if you want to attract top talent to your company, offering competitive compensation is a must.

But, outside of standard wages and benefits, what kind of payment can you offer that will make your compensation package stand out against the competition?

One option? Variable pay.

Variable pay is a win-win for businesses and employees; from a business perspective, variable pay incentivizes employees to work hard, perform, and hit goals—and from an employee perspective, it gives them a clear path to take home extra cash.

But what, exactly, is variable pay? How does it benefit your small business and employees? And when does it make sense to offer variable payments to your team?

What Is Variable Pay—and What Are the Different Types?

Variable pay is a type of incentive pay that’s offered to employees on top of their regular wages or salary when they hit certain goals or milestones. 

Variable pay (or variable compensation) is typically tied to employee performance or company performance—and may come in the form of cash payments, stock, or other types of incentives (like additional paid time off). 

There are a few different types of variable pay—and each type can be used in a variety of situations:

Performance Bonuses

A performance bonus is a lump sum payment earned by an employee for meeting or exceeding goals, quotas, or other expectations. A bonus can also be earned by an entire group for meeting shared goals. 

For example, a salesperson (or sales team) can earn a performance-based bonus for beating a monthly sales quota.

Referral Bonuses

A referral bonus is a type of incentive pay plan that rewards employees for referring job candidates to your company—typically for highly specialized and/or difficult-to-fill roles. 

In exchange for the referral, the referring employee receives one or more rewards, often tied to the referred candidate hitting certain milestones throughout the hiring process and early employment. 

For example, an employee of a construction company might refer someone for a high-level position that requires extensive experience in a specific, niche type of architecture. 

With this type of bonus, the worker might earn a gift card after the candidate is interviewed, an additional PTO day after the candidate is hired, and a cash bonus after the new hire is employed for 90 days.

Retention Bonus

A retention bonus is a type of incentive plan that isn’t tied to an employee’s individual performance. Instead, this type of variable pay plan rewards employees for staying in their jobs and with your company for a certain amount of time—typically after some sort of major transition, like a merger.

Generally, retention bonuses are paid out at a percentage of the employee’s annual salary, either in one lump sum or over time in installments.

Commissions

With this type of variable pay, an employee earns a percentage of every sale or deal they close—known as a commission. 

Commissions incentivize sales teams to work harder to close deals, increasing the employee’s income and bringing in extra revenue for the company. 

The size of a commission can vary based on the type of product or service being sold—and the total commissions earned can also vary based on a variety of factors, like the employee’s productivity, the quality of their leads, and the time of year. 

For example, an insurance agent might earn a sales commission after selling a new policy to a client.

Employee Stock Options

Instead of a cash payment, variable pay can also take the form of an employee stock option (ESO). With this type of variable compensation, you reward employees with company stock—or give them the option to purchase that stock at a set price (with the idea that the value of the stock will be higher in the future). 

In addition to the financial reward, stock options can also make employees more invested in the success of their company—since the value of their stock is directly tied to their success.

Many startups use ESOs as forms of variable compensation, including Google—which famously rewarded their team (including part-time employees!) with stock options that eventually proved extremely lucrative.

Profit Sharing

When your company smashes your revenue goals, one great way to invest those profits is by sharing the wealth with your employees—and actually rewarding them with a share of the profits, known as profit sharing. 

Because a profit-sharing plan depends on factors you don’t have full control over—and your profits will change year to year—it’s considered variable pay. It’s added onto an employee’s regular wages, generally in the form of a bonus, retirement contribution, or stock option.

An example of profit-sharing might be sharing 5% of your company’s annual profits with your employees as end-of-year bonuses after the company surpasses its annual revenue goal of $1M.

Differential Pay

Some employees work outside of regular business hours or situations—like those who are on-call or who specialize in highly dangerous work. 

Differential pay is a type of variable payment that workers earn on top of their normal pay in exchange for working during irregular hours, circumstances, or conditions.

For example, an employee who volunteers to work on a holiday might be rewarded with differential pay on top of their existing hourly wages. Or, a lineman dispatched to work in a disaster might earn differential pay while on site.

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Traditional vs. Variable Pay

Traditional pay is the regular compensation employees get for doing their job, while variable pay is supplemental pay employees earn through achievements (like with sales commissions) or loyalty and commitment to the company (like with a retention bonus).

Traditional pay is fixed and based on the amount of time an employee works in a given pay period and is paid out on a scheduled basis. 

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With variable pay, the payment schedule and amount can change. Payouts can be added on top of an employee’s scheduled compensation or awarded off-schedule, including at the end of the month, quarter, or year. Variable pay also isn’t guaranteed.

Meanwhile, traditional pay is consistent; if an employee regularly works 40 hours, they can expect to earn the same amount of compensation every week. But that’s not where the differences end!

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Employees typically and consistently receive traditional pay via cash, check, direct deposit, or payroll card. On the flip side, variable payments are paid through a variety of methods and can include anything from a lump sum cash payout added to an employee’s check, stock, additional PTO, or other forms of compensation. On top of that, this type of pay may be taxed differently. For example, bonuses can be taxed at a 22 percent flat rate.

The Benefits of Variable Pay for Your Business

Variable compensation helps your employees earn more. But how does it benefit your small business? Some reasons to consider offering variable pay include:

• Increases employee productivity and performance: A variable pay system incentivizes your employees to work harder and perform better by rewarding them with financial incentives for meeting business goals. This gives employees something tangible to work toward, encouraging them to make more sales, produce more goods, and work more efficiently—all of which directly benefit your company.
• Improves employee engagement and retention: A variable pay program rewards employees for good work. In turn, your workers are more engaged in working toward shared goals. Some incentives can even help retain employees by rewarding them with additional bonuses the longer they stay with your company.
• Supports business cash flow and profitability: With a variable pay program, payouts typically stem from revenue-generating activities. In other words, you don’t need to tap into your cash flow to pay out an incentive the same way you do with salary. For example, if the sales team’s performance exceeds its monthly goals, you have that extra cash flow to pay out commissions—but if they don’t close enough deals, you don’t have to pay any commissions (and your current resources stay intact). 
• Makes your employee compensation strategy more competitive: As mentioned, job seekers place a heavy emphasis on employee compensation when determining if a job is a good fit. Offering variable pay can help make your company seem more appealing—which will help your business attract and retain top talent.

When Does It Make Sense to Offer Variable Pay?

Variable compensation isn’t ideal for every small business, type of employee, or situation. So, when should you consider implementing a variable pay system?

To Encourage Better Performance

If you operate a sales-driven business, it can make sense to offer your sales team incentives for meeting or exceeding goals. 

Similarly, if you work in manufacturing, you can reward workers with variable compensation for exceeding production goals—even if those incentives are only limited to periods of high demand (for example, the months leading up to the holiday season). These types of employees typically earn incentives like cash bonuses and commissions. 

In contrast, these types of incentives generally don’t work for employees that aren’t directly engaged in generating revenue, whether on the sales or production side. 

For example, human resources, receptionists, or custodians might prefer steady and consistent income vs. pay that fluctuates.

To Motivate Leaders

Managers and leaders set the tone for your entire company. If they’re successful and invested in helping their teams excel, your company is stronger as a whole. 

Variable pay, like bonuses and stock options, helps attract better leaders and managers and gives them a high bar for success—both for themselves and for their teams.

In many cases, this type of employee compensation takes the form of annual or quarterly performance bonuses, profit-sharing, or stock options.

To Reward Risk and Selflessness

Some roles or tasks require employees to put themselves in danger, work in hazardous conditions, or sacrifice their free time in favor of getting the job done. 

Variable pay can make it easier to find high-quality talent to fill these roles—and show those employees that you appreciate their efforts and are invested in their success.

Use Variable Pay to Take Your Business to the Next Level

Pay is one of the most important motivations for your employees to show up to work every day and get their jobs done. 

And while competitive base compensation is a must, offering additional variable pay can help you attract and retain the best talent—and incentivize them to perform at the highest level. 

And now that you understand the different types of variable pay—and when to use them in your business—all that’s left to do? 

Get out there, create your compensation plan, and use variable pay to take your business to the next level.