Bonus Pay: Definition, Types, and Tax Implications

Globalization in the workplace has opened newer avenues of opportunities, benefitting both employers and employees. 

While you have an unlimited pool of global talent to hire, employees enjoy better mobility and pay. Sometimes, this can lead to higher employee turnover as workers seek better opportunities and higher salaries.  

To overcome it, you can rely on an effective employee compensation tool like bonus pay. It serves as a powerful tool to recognize achievements, boost motivation, and reward contributions beyond regular salaries. 

You can tie it to individual performance, team milestones, or company profitability to instill employee satisfaction and retention. 

In the following sections, we will explore the significance of employment bonus and cover how bonuses work, and various types of employee bonuses, from performance-based incentives and signing bonuses to retention and holiday bonuses, that you can offer. 

Additionally, we'll address the important tax implications of bonus payments and look into best practices for implementing an effective bonus pay policy.

What is Bonus Pay?

Bonus pay is one of the most effective ways to maintain a competitive workforce within your organization. Unlike regular employee salary, you are not liable for bonus salary. 

You can vary employee bonuses based on individual performance, team performance, company profits, or expansion goals. 

Definition of bonus pay

In the United States, workplace bonuses are legally categorized into two main types: 

• Discretionary 
• Non-discretionary

You must clearly distinguish between these bonus incentives for employees as it affects compliance with wage and hour laws, including overtime calculations and tax withholdings.

Discretionary employment bonus allows you to dole out incentives at will, often as a reward for exceptional performance or as a holiday gift. 

According to the Code of Federal Regulations, a discretionary bonus is one in which "the employer retains discretion both as to the fact of payment and as to the amount until a time quite close to the end of the period for which the bonus is paid."

You are obligated to pay non-discretionary bonuses for employees because it’s promised in advance and tied to specific, measurable criteria. 

Bonus pay could be for meeting sales targets, productivity goals, or other performance metrics. 

Importance of bonus pay

Implementing a well-structured bonus for employees system can be one of the most effective strategies for elevating employee experience. 

Here’s why they matter:

• Enhancing employee satisfaction: Employees who feel appreciated are far more likely to be satisfied with their jobs and remain loyal to your organization. The best bonus pay example could be offering annual performance-based bonuses to make your employees feel rewarded for meeting or exceeding goals.
• Motivating employees to perform: Bonus pay is a great measure to align your employees’ efforts with your company’s goals. For instance, offering a sales bonus for exceeding monthly targets pushes your sales team to increase revenue while driving company growth.‍
• Retaining top talent: Bonus and incentives help retain employees to stay with your company long-term. You can provide annual bonus for retention or stock options to ensure that employees stay invested—both financially and emotionally—in your company’s success.

Types of Bonus

Bonus given to employees can take various forms, matching your specific business goals: 

Performance-based bonuses

Such types of bonuses are directly tied to measurable performance like: 

• Individual Performance Bonuses: Awarded to employees for meeting or exceeding personal targets, such as sales quotas, productivity goals, or project deadlines.
  • Example: A salesperson earns a bonus for surpassing their annual target by 20%.
• Team Performance Bonuses: Designed to reward collective success, encouraging collaboration and teamwork.
  • Example: A production team receives a bonus for reducing defects and improving output by 15%.
• Milestone Bonuses: Given when significant achievements are met, such as completing a major project, launching a new product, or hitting a key revenue goal.
  • Example: A development team is rewarded for delivering a software update ahead of schedule.

Signing bonuses

Signing bonus pay is a one-time incentive offered to new hires to attract top talent, particularly in competitive industries where demand for skilled workers is high. 

You can award such bonuses to help secure candidates with multiple job offers.

Signing bonuses are common in technology, finance, healthcare, and sports industries.

Referral bonuses

Referral bonuses are incentives for current employees who successfully refer qualified candidates for open positions. You can reduce hiring expenses at the same time improve employee engagement and retention by involving them in the hiring process. 

Retention bonuses

Retention bonuses are financial incentives for retaining key employees during critical periods, such as organizational changes, mergers, or economic downturns. 

Such type of bonus is especially effective in industries where employee expertise is critical, such as technology, pharmaceuticals, and consulting.

Holiday bonuses

Unlike performance-based or retention bonuses, holiday bonuses are typically not tied to specific achievements but are instead discretionary: 

• In the United States, holiday bonuses may take the form of a flat cash amount, gift cards, or extra pay.
• In European countries, holiday bonuses (often called a “13th-month salary”) are standard in many employment contracts.
• In India, holiday bonuses may be tied to festivals like Diwali, where companies provide cash bonuses or gifts to employees.

Tax Implications of Bonus Pay

Bonus payments are part of an employee's income. However, tax laws on bonus payments differ by region and country. There could be special tax implications for remote workers too. Let’s explore further. 

Are bonus payments taxable?

Yes, bonus pay is generally taxable, meaning you are liable for withholding bonus payments. 

Bonuses are treated similarly to wages and salaries and are subject to income tax, social security contributions, and other statutory deductions.

• In the United States, the IRS treats bonuses as supplemental income, which is taxed differently than regular salary.
• In the European Union, tax treatment of bonuses varies depending on national laws but is generally subject to income tax and social insurance contributions.
• In India, bonuses are added to annual income and taxed based on the individual's income tax slab.

Federal tax on bonus pay

Under the IRS guidelines, bonus pay is considered supplemental income and is taxable at the federal level. You can calculate withholding federal tax on bonus pay using two primary methods:

1. Percentage method: Taxation on bonus payments is at a flat rate of 22% (as of 2024). You can calculate tax withholdings on this separate payment. 
2. Aggregate method: When bonuses are paid with regular wages, you can calculate bonus pay withholding based on the employee’s overall tax bracket.

Withholding bonus payments

You must handle bonus tax withholdings carefully to comply with IRS regulations. Key considerations include:

• Use either the percentage method (22%) or the aggregate method, as explained above.
• Bonus salary is subject to FICA taxes (6.2% for Social Security up to the wage base limit, and 1.45% for Medicare, with an additional 0.9% Medicare tax for high earners).
• Depending on the state, bonus pay may also be subject to state income taxes. Some states have a flat supplemental income tax rate (e.g., California taxes bonuses at 10.23%).

Most tax advantaged way to give bonus to employees

Not all bonus payments are taxed. 

For example, the IRS in the United States considers the concept of De minimis fringe benefits. 

Employee bonuses in the form of occasional tickets for events, occasional snacks, holiday gifts, occasional meal money transportation money for working overtime, flowers, and other items given for special occasions are not taxed. 

Furthermore, you can frame a unique bonus pay policy to minimize tax liabilities by the  following: 

1. Non-Cash Bonuses: Providing non-cash rewards, such as gift cards, company merchandise, or experiences, may help reduce tax burdens. 
2. Profit-Sharing Contributions: Bonuses can be allocated to retirement plans like a 401(k), which defers taxes until withdrawal.
3. Equity or Stock Options: Offering stock options or restricted stock units (RSUs) can defer taxation until employees sell their shares.
4. Charitable Contributions: You can offer bonuses as charitable contributions in the employee’s name upon prior consent. ‍
5. Structured Bonus Payouts: You can lower immediate tax withholding liabilities by distributing bonus pay over multiple periods instead of a lump sum.

Eligibility for Bonuses

You can determine eligibility for a bonus based on the following factors: 

• If the company meets or exceeds its financial goals, you may give our bonuses to employees.
• Bonus pay can depend on performance reviews, achievement of specific goals, or exceeding expectations in one's role.
• In some cases, bonuses may be tied to the performance of an employee's department. This can incentivize teamwork and collaboration.
• You can offer bonuses based on an employee's length of service with the company. This can be a way to reward loyalty and experience.
• Further, you may withhold bonuses from employees who have excessive absences or disciplinary actions.

The only employees who should receive bonuses

There is some debate about whether all employees or only high performers should receive bonuses. 

The most recommended approach would be to follow a tiered bonus pay policy—rewarding all employees with a base-level bonus while reserving larger, performance-driven bonuses for exceptional contributions.

How to determine bonuses for employees

Here's a breakdown of guidelines on how much is a typical bonus based on performance metrics, company profitability, and industry standards:

1. Performance metrics

Consider a sales representative to have the following metrics:

• Sales revenue (60% weight)
• New customer acquisition (30% weight)
• Customer retention (10% weight)

Based on the assigned weights to different metrics and their performance against these metrics, you could pay a bonus of 5%, 10%, or 15% of their base salary.

2. Company profitability

Consider allocating, say 10% of annual profits to the bonus pool. If your company exceeds the profit target by 20%, the bonus pool could increase to 12%.

3. Industry standards

• Research industry surveys and reports to understand typical bonus practices and amounts for similar roles and industries.
• Factor in location-specific cost of living and current market conditions, as these can influence competitive bonus amounts.
• You can also include a policy for paying bonuses to employees on leave of absence to be an employee-centric organization.

Best Practices for Implementing Bonus Pay

According to the Fair Labor Standards Act (FLSA), you can consider bonus pay as part of regular salary and must include it in the calculation of overtime pay for non-exempt employees. 

Further, here are some recommended strategies to calculate bonus pay:

How to calculate bonus pay

When do companies give bonuses?

Interestingly, timing your bonus pay is also critical in uplifting your employee morale and the effectiveness of the bonus program. It could be fiscal year-end, project completion, holidays, or even spontaneous rewards.

Bonus pay policy

A well-defined bonus pay policy ensures fairness, transparency, and alignment with company goals. A robust bonus pay policy should clearly define:

• Eligibility: Who qualifies for bonuses (e.g., job level, employment status).
• Bonus Types: What kinds of bonuses are offered (e.g., performance, profit-sharing, spot)?
• Performance Metrics: How performance is measured to determine bonuses.
• Calculation Methods: How bonus amounts are calculated (e.g., percentage, fixed amount).
• Payout Schedule: When bonuses are paid (e.g., annually, quarterly).
• Policy Review: How often the policy is reviewed and updated?

More importantly, you should communicate business goals and milestones to achieve frequently for employees to stay aligned and motivated.

Challenges and Considerations

You will face challenges in implementing an effective workplace bonus policy. It could be in the form of unclear metrics to calculate bonus pay, perceived unfairness, lack of communication, or budget constraints. 

However, with the following considerations, you will understand the right time as to when do bonuses get paid out: 

Bonus inflation

Bonus inflation refers to the phenomenon where the value and impact of bonuses decrease over time due to increased frequency, larger amounts, or broader eligibility. However, you can manage bonus inflation, you can:

• Define purpose, eligibility, and calculations.
• Link bonuses to specific, measurable performance
• Ensure alignment with company goals and market conditions.
• Offer non-monetary rewards like promotions or time off.
• Lastly, emphasize the overall compensation package, not just bonuses.

Paying bonuses to employees on leave of absence

Here's a table summarizing considerations for bonus payments to employees on leave of absence:

How Skuad Helps

We have explored everything you need to know about bonus pay, a powerful tool to incentivize employees, boost morale, and retain top talent worldwide. 

However, implementing bonus pay effectively can be challenging on a global scale.

Fortunately, Skuad’s Employer of Record (EOR) platform can help! 

Skuad offers a comprehensive platform for hiring employees and independent contractors in over 160 countries, ensuring compliance with local regulations. 

You can manage payroll and taxes seamlessly, including bonus payments, for your global workforce. 

Further, you can streamline employee onboarding, benefits administration, and performance management.

Ready to take your global talent management to the next level?

Schedule a demo with us today to learn more use cases.

FAQs

1) How does bonus pay work?

Unlike regular salary, bonus pay is an additional form of compensation that acts as a reward for accomplishing pre-determined goals and milestones. Sometimes, bonus pay can be awarded for specific employee achievement spontaneously. 

2) How is the bonus paid?

Bonuses are paid in both cash and non-cash options including stock options, gift cards, additional holidays, and more.

3) What are the rules for bonuses?

The rules for employee bonuses are to keep the targets and goals realistic and practical. You can vary bonuses based on employment laws, tax regulations, and company policies. Further, avoid over-promising your employees and under-delivering. 

4) Are bonuses taxed higher at 25 or 40 percent?

Bonus are not taxed directly at 25 or 40%. Under the IRS, bonuses are treated as supplement income and form a part of regular salary. You can withhold taxes at a flat 22% on the bonus salary or consider it a part of the total income and apply the relevant tax rate.