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Please note that this article is intended for educational purposes only and should not be deemed to be or used as legal, employment, or tax advice. For guidance or advice specific to your business, consult with a qualified tax and/or legal professional.
Employee bonuses are a form of compensation that allows you to reward your team beyond increasing their salaries. They’re in addition to what your employees already earn, and they don’t only come in the form of cash.
When used effectively, employee bonuses can help you hire, motivate, and retain a talented team. This is increasingly important as small businesses adapt during the pandemic, while some are also having trouble hiring despite high unemployment rates.
It can be difficult to know the options that will help you offer bonuses strategically. We’ll break down the different types of employee bonuses to choose from, what they’re used for, and tips for communicating the decision to your team.
The different types of employee bonuses
There are a few ways to classify employee bonuses, but you can typically think of them as performance based or not.
A performance bonus is determined by how your employee performs in their role. It can be given at the end of the year, around their performance review, or at another meaningful milestone. A bonus that isn’t performance based can be a holiday bonus or a referral bonus, for example.
Depending on the type, employee bonuses have different purposes. Some are intended to offer extra motivation during a busy time, while others may be used to thank the team for hard work. Here are a few common types of employee bonuses small businesses might offer
Employee referral bonus
Employees who refer candidates to open roles may receive this type of bonus. Some employers provide a bonus just for the referral, while others may require the new hire to accept the offer and stay in the role for a certain amount of time before the bonus is paid out.
Goal: To help build a bigger candidate pipeline when hiring employees.
A signing bonus, or sign-on bonus, can be given to candidates to entice them to accept a role. It’s a lump sum payment, and doesn’t have to be given to each new employee you hire.
Some employers offer signing bonuses to incentivize candidates to accept hard-to-fill roles.
Goal: To make a new hire’s total compensation package more attractive, enticing them to accept the role.
In 2019, two out of three employers offered employee bonuses during the holidays. In 2020, these numbers will likely look different.
A holiday bonus is a gift employers give to all employees (within a classification group) to show their appreciation. Unlike the year-end bonus, it’s typically not based on performance, so elements like tenure and salary are not taken into account. A holiday bonus can be monetary, or it can take the form of a gift card, a physical gift, or even paid time off.
Goal: To show appreciation for your team.
A year-end bonus, or annual bonus, is performance based and typically given at the end of the year. Some year-end bonuses are tied to overall business performance or in addition to an employee’s individual performance goals.
If you’re giving employees both holiday bonuses and year-end bonuses, you may want to stretch out the time in between giving each bonus so employees are clear about the type they’re receiving.
Goal: To reward employees for business and/or individual performance.
A spot bonus is a smaller amount that managers can give to recognize employees “on the spot.” Spot bonuses are less structured and can happen spontaneously. A good rule of thumb is to give spot bonuses right after an employee does something exceptional. That way, it’s obvious what the bonus is connected to.
Goal: To spontaneously recognize employees for jobs well done.
Often confused with sales commissions, sales bonuses are a fixed amount employees can receive for hitting specific sales targets.
Goal: To incentivize salespeople to hit their targets.
The goal of this type of bonus is to keep an employee at your company for a specific amount of time. There is some disagreement about whether retention bonuses are effective in preventing employees from leaving.
Goal: To incentivize an employee to stay at your business.
Structuring your bonus plan
Like anything related to your business, it’s important to have guardrails in place before you kick your bonus plan into motion. Learn about your team’s preferences, research industry benchmarks, and determine your budget before you offer your team bonuses.
Here are a few areas to review when structuring a bonus plan.
The bonus calculation: You can offer a percentage, fixed amount, or even non-monetary compensation, depending on the type of bonus you’re offering. You can also offer tiered bonus levels, so employees receive a certain amount for hitting an easier goal but a higher amount for achieving the more challenging goal. This can help motivate your team to hit the more difficult target.
Whether it’s connected to specific results: Once you decide on the bonus method, some experts, like Amy Gallo from the Harvard Business Review, say it’s important to connect the bonus to tangible goals. Establish goals, explain how they can be achieved, and set the bonus employees can receive for hitting those goals.
The amount: Bonuses are meant to incentivize employees, so it’s important to make sure the amount or non-cash compensation is meaningful enough to motivate employees to achieve their goals.
How you’re communicating it: You want your team to know about the bonus, why you’re giving it to them, and if they didn’t get it, what they can do to get it in the future. Communicate this information when you give your employees their bonuses. Depending on the type of bonus, you may also need to include the details in your offer letter and other relevant employee documents.
As with other employment agreements, you may want to consult with an attorney to ensure that your bonus plan complies with all laws that are applicable to your business.
Whether you’re giving bonuses or not this year, be transparent about the decision. If anything regarding employee bonuses has changed from last year, it’s particularly important to tell your team as soon as possible.
Managing your team’s expectations is important, because many people plan around receiving their bonuses, whether it’s for holiday gifts, tuition payments, or making another big purchase. If you’re able to, be up front about whether you’re offering the bonus, and if you are, the types your team will be eligible for. Transparency around bonuses is essential, especially during challenging financial times.
An important note on taxes
Wherever you land on the bonus decision, don’t forget about the tax implications. Taxes lower the total amount your employee will be able to take home, so it’s important to factor in that amount during your planning.
Employee bonuses are seen by the IRS as supplemental income. Depending on where your employees live, the bonus can also be subject to state taxes. Talk to a CPA or other tax professional for guidance specific to your business.
Some types of payroll software allow you to process bonus payments made directly to employees. Taxes are calculated automatically, and you can usually choose which type of bonus taxation method you’re going with. Typically, you’ll have to run an off-cycle payment since bonuses are not usually included in your employees’ paychecks.
Not all bonuses are the same. Once you understand the different types and how they can be used, you’ll be more prepared to roll out a bonus plan that makes the most sense for your business.