How To Create A Compensation Plan in 6 Steps

If you own a small business, you need to learn how to pay your employees–it’s that simple! In this article, we are going to walk you through how to pay your employees, from how to establish a compensation plan all the way through to picking a payroll provider.

Step 1: Establish a Pay Philosophy

The first step in designing an employee compensation plan is deciding what your pay philosophy will be. This means you need to think about not just how much you want to pay your employees, but what we call a “total compensation plan”- a compensation plan that includes other factors like benefits, performance bonuses, incentives, and company-provided perks like gym memberships or free lunches.

In this step, you should ask yourself questions such as:

• Do I want to pay more or less than those companies that compete with me for talent? (your location and industry will help determine your answer to this question)
• Do I want to give a lot of other benefits, like health insurance, or fewer benefits so I can pay more in salary?
• How do I want to incentivize performance? Do I want to have a bonus or commission plan and create an incentive compensation plan?
• Will everyone be on the same compensation plan or will managers, my business partners or fellow owners, and I be on a different plan? Why or why not?
• Are most of my employees salaried or paid hourly? Exempt or non-exempt? W2 or 1099?

Throughout each stage of developing your total compensation plan, you should test yourself by asking if the plan meets the needs of all three of the primary stakeholders in the company, which are:

1. Employees – Are you providing fair compensation? Will employees be motivated to work for you?
2. Clients – Will employees be serving your clients in a genuine way? Meaning, if you sell products and use commissions as a main source of pay, will your employees now be hounding your customers for products they don’t want? This can backfire on the business.
3. Owners – Will the pay philosophy keep the business owners motivated and rewarded for their risk and hard work?

Step 2: How Much is Your Competition is Paying?

When thinking about the fairness of their compensation, employees are going to focus their attention in large part on how much they are being paid relative to similar positions at other firms and other positions within your firm.

If you have not done so already, you will need to put together a job description for each of the positions in your company so you can compare what you are paying with the competition. We have a simple guide on how to do this here, and we also have specific articles for administrative assistant and sales coordinator roles.

Once you have an outline of the duties and responsibility level of each position, then you can find out what other businesses who are offering similar positions are paying.

There are three primary ways to do this:

1. Talk to people within your industry and ask them what they are paying. Make sure you describe the duties and responsibilities of the position so you can compare apples to apples. You could also use a forum on LinkedIn to do this online.
2. Use Indeed.com’s salary calculator or a website like PayScale, Salary.com, or Glassdoor.
3. Look for salary surveys online by searching “Your Industry + Salary Survey” on Google.

By now, you should have some data on what companies in your area and with comparable jobs to your company’s are paying, and you’ll want to compare it to what you are currently paying, or to what you had budgeted for. Do you need to recalibrate to fit your budget? (like look at less or more experienced employees)?

With your research in hand, as well as factoring in what your employees consider to be fair, you can then move to step 3:

Step 3: Set the Salary Level or Hourly Pay Rate

Competitive compensation is necessary for an employee to be happy, but it is not always a motivator for better performance.

With this in mind, we generally recommend paying salaries that are in line with your competition, meaning small businesses in your city and industry.

Exceptions to this rule would be:

• If you feel a role is particularly valuable to your firm and warrants paying above the competition
• If you have a role that is not very important, and you feel you can pay less
• If you have a strong performance incentive or bonus system where the employee can receive higher compensation based on good performance

You must also keep in mind how salaries will be viewed internally. The salaries you choose, even if you think employees won’t or aren’t supposed to share them with each other, need to be fair in the context of the responsibilities and experience required to do this job versus others. You also need to ensure you are not paying with any discriminatory practices. For example, all of the male sales reps cannot have a higher base pay than the females, which can land you in hot water.

Things to Consider When Choosing Salary Versus Hourly

Here are some things you will want to think about when deciding whether to pay employees hourly or with an annual salary:

Industry and Role

Conventions on pay differ based on the industry and position. For example, hourly pay is appropriate for a restaurant waiter or convenience store cashier, but likely not for the restaurant general manager. Similarly, salary may be more appropriate for a marketing associate at a PR firm or a writer at a publication. You can find out more about your industry by researching the competition and talking to fellow business owners.

You may lose talent to your competitors based on your choice of hourly versus salary. Say you have a small marketing agency but you want to pay hourly (which is not the norm for that industry). You might lose talent to a competitor providing a salaried income — how can you get them to stay if you really want to pay hourly (think benefits, bonuses, office environment)?

On the flip side, if you are in an industry that tends to pay hourly with no paid time off, and you decide to pay salary (e.g. baristas at your cafe), you might get the best applicants banging down your door to come work for you!

Overtime Pay

If you choose to pay hourly, unless you are paying a significant amount per hour like $25/hour+, you will need to factor in the possibility of overtime. Overtime kicks in an hourly rate x 1.5 after 40 hours worked in 1 calendar week, and then double overtime (hourly rate x 2) kicks in for other states at a certain point as well. You can learn more about overtime state by state here, or read our article on exempt vs non-exempt.

If you choose hourly, check out our time-tracking software guide, our time and attendance software guide, and our employee scheduling software to help you avoid huge overtime costs.

Fear of Paying People to Do Nothing

Both kinds of pay bring up the same fear from small business owners — what if I am paying people to stand around? With hourly employees, you might find people clocking in early while they then take off their coat, use the washroom, and make themselves a cup of coffee (or other things like this throughout the day). With salaried employees, you wonder the same thing- “Well, jeez, Donna took a 2-hour lunch during her day and still left at 5 pm.” These are horses of the same color- you need to stand your ground and communicate firm rules to your employees on expectations.

What About Benefits?

As you set your employees’ base salaries or hourly pay rates, you also need to factor in if you will be offering them benefits as part of compensation. Some benefit plans, like PPO health insurance plans, can be worth well over $10,000/year to employees! You will want to make sure you consider offering the following:

• Health insurance – here’s a full guide on how to do it, or a shorter guide on the types of plans you might consider
• Dental and vision insurance
• Retirement plans
• Life insurance, tuition reimbursement, and other perks

For a 401(k) solution that your employees will love and won’t cost you a fortune, you may want to check out Human Interest. Their dedicated account managers will provide compliance support and help your employees choose great low-fee options for their investments. For a company with 20 employees, it would cost $200 per month. Click here to get more information.

Visit Human Interest

Once you have picked salaries and benefit packages for everyone, you’ll want to then think about if you want to create bonuses for performance.

Step 4: Create Incentive Compensation Plan Components

Paying for performance is a controversial subject. You might read from one blog that paying for good performance is not a motivating factor for many employees (versus other things like company culture and being praised). You might then read a book or magazine that says the only way to motivate people is to pay them well.

Our advice is to think about your company and its culture, or the culture you are trying to create. For example:

• Do you want a Jack Welch-like GE situation where the bottom 10% are cut every year for their performance?
• Do you want a community-like culture where sales and achievements are shared among teams or all employees together (i.e. company-based performance bonuses)?
• Do you want to have a combination of the two, where you perhaps have contests for small bonuses on a weekly or monthly basis?

If you decide to implement a pay-for-performance system, such as if you have a sales team or another role that usually has a sales component, you might want to consider how the policy you are creating will:

• Enhance employee satisfaction
• Improve company processes or results and customer satisfaction
• Help with implementing new products or protocols
• Provide innovation or cost-savings to operational methods

Basically, how will a performance bonus system impact your business as a whole, not just your employees?

To expand, check out this table on performance incentive ideas and situations they may or may not work in:

Pay-For-Performance Comparison Table

Whether or not you choose to have a bonus or incentive program, you might also want to think about offering periodic pay raises.

Step 5: Pay Raises

Once you have your base level of compensation set (aka salary or hourly rate plus incentive plan if you have one) for each level of employee, you want to consider budgeting for pay raises to reward your top performers and make sure that your salaries keep pace with inflation.

The first thing you want to do when budgeting for raises is to make sure that your job descriptions and salary ranges for each job are up to date. If your salary ranges have become outdated, then you may need to factor in a raise for everyone in order to get your employees back in line with your competition.

Once you have made sure that your pay is still fair relative to the competition, you will want to make sure that pay is fair internally as well. To do this, you will want to consider implementing a performance management system, which we walk you through here.

At the very least, we suggest creating some sort of ranking system (i.e. by behavior and by performance as 2 separate categories) and make sure that employees are being compensated in alignment with their ranking. While this is easy to do with sales positions, you might find trouble doing this with, say, your accounting team, which is why we recommend implementing performance management as a way to be fair with your employees.

Once your pay practices are in line from both an external and internal standpoint, you can look at rewarding top performers with raises. It is important to give raises at the same time that performance reviews are given. That way, employees understand that there is a well thought-out process behind the raise and that they are not just being given a raise on a whim. Keep in mind that it is about percentages and not the total dollar amount. Anywhere from a 0 to 5% bump in salary is the norm for most companies for pay raises, and companies rarely raise someone more than 10% in any one year, unless a promotion is also given and the person’s duties and expectations have expanded (which then can call for a 10%+ pay raise).

Step 6: Choose Your Payroll Software

Once you have your compensation strategy set, it’s time to make sure you have the systems in place to successfully implement that strategy. You will need to set up several components, including state and federal tax forms and workers compensation coverage.

This is why we recommend taking the headache out of payroll by using payroll software, which can take care of all of these things for you for a reasonable monthly fee. For more information, see our buyer’s guide on how to choose the best payroll software for your business as well as our article on how to run payroll.

We recommend Gusto as the best payroll provider for small businesses. This reasonably-priced software automatically calculates and files payroll taxes, issues payments via direct deposit, generates year-end W-2s and 1099s, helps you shop for employee benefits, and more. Click here for a 30-day free trial.

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Top Factors For Deciding a Compensation Strategy

Compensation isn’t as simple as dollars and cents. Here are our top factors you will want to consider for creating your total compensation plan, in addition to the 6 steps above.

Factor 1: What Motivates Your Employees?

Surprise, not all employees are motivated by pay! Some value things like the value of their work to the client, the value of their work to society, the opportunity to work with or manage great people, and other things. So, you may even consider doing an employee survey on what motivates your team before you consider giving raises or creating a complicated incentive compensation plan.

Some other ideas for compensation include providing a free gym membership to a local gym, parking passes, or try our Employee Recognition Ideas article or our Employee Engagement Ideas article (totaling over 50 ideas between the two articles!).

Factor 2: What is Your Budget?

Yes, of course, you would pay everyone what they wanted if you could. But you can’t. So look at your budget, do the salary research we talk about in step 2, and then be realistic – can you afford what you think you need to pay or do you need to recalibrate your expectations (i.e. by hiring people with less experience)?

Factor 3: What is Your Location?

If you are in a major city like NYC or San Francisco, you know how expensive housing is getting. Well, you need to create a compensation plan that lets your business survive and lets your employees pay their mortgage or rent and keep up with the cost of living. So make sure that you factor in your city’s inflation rate, as well as the cost of housing, transportation, and parking when you think about compensation.

This is when you could also consider hiring remote employees if you are in a high cost of living area in order to save money. Here, we talk about independent contractors versus employees, and then we also talk about where you can find remote and freelancers employees in our job sites article.

Factor 4: What is Your Competition Paying?

If you are a small software company, you probably aren’t competing with Apple for talent. But you might be competing with that business two neighborhoods over that is selling a similar product or service. If you can, look them up and see if you can find job postings with salaries attached to them. You can easily do this on Indeed or on Glassdoor.

Factor 5: What Kind of Culture Are you Creating?

Compensation is certainly tied to culture. One client I did work for created amazing software that is helping to cure cancer, so they could pay less because their work has huge meaning to the planet or to people who work there who have personally dealt with cancer. Another client was located in a remote location and everyone worked from home. He didn’t provide benefits, but he provided huge salaries to compensate for it.

The Bottom Line

The 6 steps above are designed to give you a step by step process that any company can follow to design the pay portion of their compensation package. Once you have your package designed, give it one final check over to make sure it meets the following points:

• Is it simple and easy for everyone to understand?
• Does it align employee, client, and owner interests?
• Will it be seen as fair by the employee when comparing similar jobs both internally and externally?
• Does it align with your budget and cultural needs?