Must Incentives Be Included in Hourly Workers’ Regular Rate for OT?

The “no tax on overtime” provisions under the recently signed H.R. 1 (also known as the “One Big Beautiful Bill Act”) law are in the news, but what counts when it’s time to actually calculate overtime (OT) rates? For instance, how should incentives be handled for non-exempt (hourly) workers in instances involving OT?

This article aims to provide some compliance clarity on that subject.

Discretionary and Non-Discretionary Pay

The basis of this issue is in understanding the difference between discretionary and non-discretionary compensation when factoring “the regular rate of pay,” which then must be applied in instances when non-exempt workers exceed their normal hours.

“Discretionary pay — such as holiday bonuses, employee-of-the-month awards, spot awards for extraordinary effort, etc. — is awarded after the fact and not promised in advance, so it does not have to be included in the regular rate of pay,” said Erika Johnson, the director of work and rewards at consulting firm WTW. “In contrast, non-discretionary bonuses — such as production or piece-rate bonuses, quality bonuses, retention bonuses, etc. — are promised based on prearranged criteria, and must be included.”

The federal Fair Labor Standards Act (FLSA) is the guiding standard. This law requires employers to pay non-exempt employees at least the federal minimum wage and overtime for any hours worked beyond 40 in a workweek. The amount of OT pay due to an hourly employee is based on the employee’s regular rate of pay and the number of hours worked in a workweek, regardless of whether the employee is paid on a piece-rate, day-rate, commission or salary basis, explained Darlene Clabault, a senior HR editor at J. J. Keller & Associates, Inc., a national compliance firm.

Under the FLSA, all compensation for hours worked, services rendered or performance is included in the regular rate of pay. But the FLSA does not address non-production bonuses, such as those for sign-on and longevity.

“Employers may exclude incentives or bonuses paid to hourly employees as a reward for service from the regular rate, provided the amounts of the payments are not measured by or dependent on hours worked, production or efficiency,” Clabault said.

What Makes a Bonus Discretionary?

Discretionary bonuses are a fairly narrow exception in rate calculations, said Keith Kopplin, a shareholder at employment law firm Ogletree Deakins.

“[It] only applies to payments when both the fact of the payment and the amount are within the employer’s discretion until at or near the end of the period to which it corresponds,” Kopplin said. “The payment also cannot be made pursuant to an agreement with the employee.”

If the employer promises in advance to pay a bonus, it has abandoned its discretion concerning it, Clabault said.

An employer that announces to employees it intends to pay them a bonus in August has abandoned its discretion regarding the fact of payment by promising that bonus. Similarly, if an employer promises sales employees a monthly bonus computed based on allocating, for instance, 1 cent for each item sold, to be paid whenever the financial condition of the firm warrants such payments, the employer has abandoned discretion concerning the amount of the bonus, even though it has retained discretion over when the bonus is paid. Therefore, such a bonus would not be excluded from the regular rate, Clabault said.

Bonuses that could potentially be discretionary include:

• Spot bonuses for overcoming a challenging or stressful situation
• Bonuses to employees who made unique or extraordinary efforts that are not awarded according to pre-established criteria
• Employee-of-the-month bonuses
• Severance bonuses
• Referral bonuses to employees not primarily engaged in recruiting activities
• Holiday bonuses

But the label assigned to the bonus, and the reason for the bonus, do not conclusively determine whether the bonus is discretionary, cautioned Clabault. The determination must be made on a case-by-case basis depending on the specific circumstances.

Examples of non-discretionary bonuses that must be included in the regular rate include:

• Bonuses based on a predetermined formula (e.g., individual or group production bonuses)
• Bonuses for work quality and accuracy
• Bonuses that are announced to employees to induce them to work more efficiently
• Attendance bonuses
• Safety bonuses (i.e., number of days without safety incidents)
• Retention bonuses

“Such bonuses are non-discretionary because employees know about and expect them,” Clabault said. “Understanding how an employee earns one might lead to an expectation of receiving the bonus regularly. The fact that the employer has the option not to pay the promised bonus does not make the bonus discretionary.”

Considering a Bonus Program?

Coordinate with legal counsel and periodically audit pay codes to ensure compliance with this area, advised Kopplin.

“If a pay code has not been used for a period of time, it might be prudent to decommission it to avoid inadvertently using it in the future for a form of payment it was not designed to process,” he said.

Also, pay attention to state laws and don’t violate the Title VII of the Civil Rights Act, added Clabault. Toward the latter, bonuses should not be biased based on protected characteristics such as gender, national origin, age, race, religion, pregnancy, disability or genetic information, but they can be based on non-protected characteristics such as job classification, tenure, contribution, merit production, education, training or experience.

“People, including employees, will talk. Bonus and pay discussions can become a distraction,” she said. “Providing large bonuses can create future disappointment if bonuses become smaller, fostering a decline in employee morale and retention.”

Clabault also noted bonuses don’t always change long-term behavior. Limit bonuses for valued activities such as employee or customer referrals and team efforts that impact the organization overall, she said. And before launching a bonus program, survey employees to get a feel for what might have the greatest impact.

If you do give a bonus, document it.

“Any non-discretionary bonus or incentive arrangement should be supported by a clear plan document that outlines the expectations for payout as well as examples of how payouts will be calculated,” WTW’s Johnson said.

Collaborate closely with business leaders to ensure the full cost impact is understood, considering historical overtime trends.

“Having clear, strong documentation and adhering to established procedures not only helps ensure compliance but fosters transparency and fairness in bonus compensation practices,” Clabault said.

Editor’s Note: Additional Content

For more information and resources related to this article, see the pages below, which offer quick access to all WorldatWork content on these topics:

• Employee Compensation
• Total Rewards