Retroactive pay, or retro pay, is a payment made to an employee to make up the difference between what they were paid and what they should have been paid. It typically occurs when there was an error in calculating pay, when an employee’s salary increase was scheduled in the middle of a pay cycle, or when a bonus is given that was earned during a previous pay period.
When people discuss retroactive pay, they may be referring to a few different things. Let’s look at each below.
Disclaimer: Fit Small Business does not provide legal or tax advice. Be sure to confirm your retro pay calculations with your HR/payroll provider or tax consultant.
Regular Pay vs Retro Pay
Regular pay is the payment made during a pay period. It’s a simple calculation of the number of hours worked multiplied by the pay rate. Retro pay, however, is the number of hours worked multiplied by the difference between what was paid and what should have been paid. Retroactive pay looks backward to the prior pay period to determine what amount of pay is missing. Here’s a simple example:
- 40 hours of regular pay at $10 per hour = $400 straight time pay
- 40 hours that should have been $11 per hour, but were paid $10 per hour = $40 retro pay owed
Payroll Rules Including Retro Pay are Mandated by Federal Law
The Department of Labor (DOL) Wage and Hour Division states that employees must be paid each pay period, and no later than 12 days from the end of the pay period. States vary on labor guidelines like minimum wage, the frequency and length of pay periods, records retention, and whether or not a paycheck must be provided immediately upon termination.
Similar to regular pay, retroactive pay needs to be paid as soon as possible to ensure federal and state labor law compliance. In most states this means cutting the employee a separate check, or paying them the back wages due on the very next pay period.
State Laws Prohibiting Negative Retro Pay or Late Payments
Several states like California, New Jersey, Texas, Illinois, and Washington won’t allow an employer to take back pay for work that has already been done and incorrectly paid for at a higher rate. As well, some states like Texas require advanced notification before pay can be decreased. In addition Illinois assesses employer penalties for late payment of wages, failure to provide a final check on time, or failure to pay out earned vacation.
Retro Pay vs Back Pay
Retro pay is not the same as back pay. Retro pay is the difference between what was supposed to be paid and what was paid. Back pay is paying someone for time worked in the past that was never paid in the first place. In everyday dialogue, the terms are often used interchangeably — albeit incorrectly.
Back pay is typically court ordered, subject to damages (which doubles the amount of back pay due), and is less common. It’s assessed if an employee wasn’t paid for all hours worked, was misclassified as exempt, or wasn’t paid overtime when they should have been.
The Fair Pay Act allows employees to review their payroll records and request back pay for up to two years. You might consider using payroll software like Gusto to ensure your employee payroll is done correctly the first time.
How to Calculate Retro Pay
When calculating retro pay, you need to ask yourself a few questions first. For example, you need to know how long the employee was paid incorrectly, what pay rate they were actually paid for the timeframe in question, and what rate of pay they should have received for that work. Other questions to ask yourself are:
- Is the employee hourly or salaried, so you know which pay rate to use
- Is the employee exempt from overtime, or do overtime hours have to be considered?
- Does the retroactive pay affect only one pay period, or more than one pay period?
- Was the retroactive pay caused by missed hours (which may affect overtime calculations and need to be paid at overtime rates) or only a discrepancy in the pay rate itself?
In most cases, even with a payroll provider, retro pay has be be determined outside of the regular timekeeping system and manually input as miscellaneous income into the payroll system.
Here are two simple ways to calculate retro pay:
Calculating Hourly Retro Pay
For hourly retro pay, you’ll need to know how many hours were paid at the wrong rate. Then you’ll need to know what the difference is between the rate paid and the rate that should have been paid. You will multiply the hours by the difference in pay rate to come up with the gross amount of retro pay. Taxes should be taken from that gross amount.
Example: 80 hours were paid to Sam last pay period, using the wrong pay rate of $10 an hour. The correct pay rate should have been $12 an hour. Here’s the math:
$12 – $10 = $2 an hour difference
$2 x 80 hours = $160
$160 is the gross amount of retro pay owed to Sam
Calculating Salaried Retro Pay
Calculating retro pay for salaried staff is a little more difficult. You’ll need to start by knowing the difference between what annual salary they were paid and what salary they should have been paid. Once you have that amount you’ll need to know the number of payroll days in the year.
Example: Sue’s annual salary was increased from $57,500 to $60,000 a year based on her performance review, and should have taken effect at the start of the month. However, the month began a few days into the pay period, so her last paycheck was paid at the old rate of $57,500, when in fact 12 days in that pay period should have been paid at the new rate. Here’s the math:
$60,000 – $57,500 = $2,500 a year difference
You’ll need to divide the salary discrepancy by the number of payroll days in the calendar year. Fortunately, you can find that out using a free calendar tool from workingdays.us.
That provides you the discrepancy in pay by day. For our example, we assumed the calendar year has 251 work/pay days. Here’s the math to calculate how much Sue was underpaid by day:
$2,500 ÷ 251 work/pay days in the calendar year = $9.96
($9.96 is the pay discrepancy by day)
The last thing you need to know is how many work days were paid wrong. Multiply the daily rate by the number of days, and you’ll have your gross retro pay amount due.
$9.96 x 12 days = $119.52
$119.52 is the gross amount of retro pay owed Sue
Retro Pay Calculator
As you can see, to calculate retro pay you need to do a little math. We’ve provided a simple retro pay calculator with a radio button option that lets you calculate retroactive pay amounts for an hourly employee, or for a salaried employee. However, our simple retro pay calendar is not able to calculate the effect of overtime in prior pay periods.
Processing Retro Pay
The best practice to manage payroll payment errors like retro pay is to process a separate payroll run, or calculate the amount manually using a free online paycheck calculator, like the one shown below. That way you can pay the employee as soon as you realize the error.
Retro pay is taxable, whether paid as a lump sum or added to the next payroll in your existing payroll software. Regardless, you’ll need to make sure you take out the correct tax deductions on the retroactive pay payment.
However, doing a special payroll run costs extra with some payroll providers that charge for each payroll process. It’s acceptable in most states to wait and add the additional amount to the employee’s check during the next pay cycle. Keep in mind, however, that if overtime is involved in the pay period in which the mistake was made, you will need to adjust for overtime hours and/or use an overtime pay rate when calculating retro pay.
Situations when Retro Pay Might Be Needed
There are common situations where retro pay might occur in a small business. It’s usually an accident that typically happens as a data entry or communications error. For example, incorrect information is input from the time card or a raise or bonus was given but not communicated to the person running payroll.
Let’s say for example, the manager promises the employee, “I’ll increase your pay $2 an hour as soon as you get your license.” The employee gets their license on May 5, and then notices the $2 pay increase wasn’t added to their May 15 paycheck. The employee then goes to the manager who will need to process the hourly difference as retro pay. Here are some more examples:
A pay raise: An employee received a pay raise of $1.15 an hour by the owner, but the owner forgot to tell payroll, so payroll ran the employee’s last paycheck using the old pay rate to calculate their earnings. The employee will need the difference paid as retro pay for all hours in the prior period back to the date the raise was to have taken effect.
$1.15 per hour x [# hours paid at wrong rate] = $ gross retro pay due
A shift differential: An employee typically works as a server, but one shift a week they work as a supervisor with a shift differential of $.50 extra per hour. The employee was paid for all hours, but eight of those hours were paid using their regular pay rate, not the supervisor pay rate, so their next check has to be adjusted with $4 miscellaneous income added as retro pay:
8 hours x $.50 = $4 gross retro pay due
Overtime: An employee worked 43 hours last week, but their time was added to the payroll as 40 hours, which is what they usually work. Their usual pay rate is $18 an hour. The additional three hours of retro pay not only needs to be paid but paid at time and a half as they are calculated as overtime in the prior pay period.
$18 x 1.5 = $27
$27 x 3 hours = $81 gross retro pay due
A bonus: The employee earned a $300 bonus for services they sold, but did not receive the bonus on the pay period. The bonus can be paid with a separate check as retro pay.
The Bottom Line
Retro pay situations happen. What’s most important for you as an employer to know is that you need to address the problem as soon as you learn about it. A best practice is to calculate retro pay and pay the employee with a separate payment, such as a check or direct deposit as soon as you discover they’ve not been paid correctly. However, in most states, you’re allowed to wait and add the retro pay amount onto the next pay period earnings.
The best way to avoid retro pay issues is to use a payroll system like Gusto that is integrated with timekeeping software, Homebase, so that you don’t end up with data entry errors as you move hours worked from your time clock to your payroll system. Gusto also provides HR and payroll support to ensure your payroll questions are answered correctly.