Understanding the different types of compensation is essential if you are a compensation specialist, HR leader, payroll specialist, business owner or manager. Businesses are legally responsible for compensating workers for their labor, of course, but you are also responsible for explaining compensation to candidates and employees. This is particularly critical during the hiring process, performance reviews, salary reviews, and stay interviews. However, the terms used in the industry to categorize and discuss compensation can sometimes be confusing.
As compensation can take many forms, it is essential that workers understand how they are being compensated, the different types of compensation that apply to them and the total value of their compensation package. Although this might seem like an over-complicated way of describing wages, it makes sense once you understand that compensation gets nuanced when broken down into base pay, commission, tips, bonuses, stock options, benefits and other types of rewards.
Let’s look at the different types of compensation in more detail.
Definition: What is Compensation?
First, let’s start with a definition for compensation. When talking about compensation, we usually mean the payment received by an employee from an employer in the form of a salary, wages, benefits and variable pay. However, it’s important to note that compensation can also refer to money that is paid to someone for something that has been lost or damaged, such as “workers compensation” for unemployed or injured workers. It can also refer to a payout as the result of a lawsuit. In a more general sense, compensation can mean anything of value given to make up for a loss, such as a paid dinner to “compensate you for your time and trouble”. The word compensation comes from the Latin verb compensare, which means to “weigh against”. In this sense, compensation is a counterbalance. Compensation usually takes the form of monetary payment exchanged for time, labor and expertise.
The different types of compensation include:
- Hourly Wages
- Sales Commission
- Stock Options
- Incentive Pay
- Other Variable Pay
- Benefits (healthcare, paid leave, etc.)
- Non-monetary compensation (recognition, meals, etc.)
How is Compensation Different from Remuneration?
If you’ve come across the term remuneration and wondered what the difference is between remuneration versus compensation, we’ll make it easy for you. There is no difference. Remuneration is a synonym for compensation. They mean the same thing. Remuneration is just used more commonly outside of the United States. Compensation is the more popular term in North America. Because PayScale currently serves clients largely in the United States and Canada, we use the term compensation rather than remuneration.
Fun fact: Remuneration is commonly misspelled renumeration.
The Different Types of Compensation: Direct, Indirect, and Non-Financial
One of the ways to categorize the different types of compensation is to distinguish direct compensation from indirect compensation. Both of these types of compensation are financial, meaning that the compensation takes the form of money or can be valued as money.
Direct compensation includes money paid to employees as cash, such as hourly wages, salaries, bonuses and commission. Wages and salary typically fall under the category of base pay whereas bonuses and commission fall under the category of variable pay.
Indirect compensation is still monetary in nature — meaning it has a financial value that can be calculated — but is not a direct payment in the form of cash. What is considered indirect compensation can vary across organizations but typically includes much of the benefits package that comes with employment, such as employer sponsored health insurance and employer contributions to an employee’s 401(k) retirement plan. Stock options and profit sharing also usually fall under indirect compensation as can some other employee benefits such as tuition assistance or a company-paid gym membership. What these examples have in common is a distinct monetary value that is not paid to the employee in actual dollars.
Not all compensation is necessarily monetary. Non-monetary compensation includes time off, flexible work hours, coaching and training opportunities, recognition and awards, some fringe benefits and other perks (like catered lunches or a company car) that may not be measured in dollar amounts as part of a compensation package but are still valuable to employees and make a difference in the workplace culture and overall attraction of the job opportunity.
However, different organizations disagree on which benefits constitute indirect compensation versus non-monetary compensation. The line between them is gray, especially in organizations that do not share the cash equivalents of benefits with employees or have not calculated the cash equivalent at the individual employee level.
The Four Major Types of Direct Compensation: Hourly, Salary, Commission, Bonuses
When asking about compensation, most people want to know about direct compensation, particularly base pay and variable pay. The four major types of direct compensation are hourly wages, salary, commission and bonuses. In service-oriented industries, especially in retail and accommodation, tips are also sometimes included as one of the major types of compensation. However, as PayScale focuses primarily on professional occupations, we omit tips from our list.
Of the four major types of direct compensation, employees are paid on either an hourly or salary basis. Wages, whether hourly or salary, are what make up base compensation. Hourly wages are more traditionally assigned to unskilled or semi-skilled labor while salary employees are usually the more well-educated employees or employees who occupy management positions. Hourly wages are also used to compensate temporary, part-time or contract workers while salaries are more common for employees that the company has invested in for the long haul.
Of course, this is not universally true. There are many examples of highly educated, highly skilled, highly valued workers who are paid hourly, and these employees can often benefit from non-exempt status (i.e. eligible for overtime pay). There are also many examples of salaried employees who are not in management positions and/or who are non-exempt. The rules for compensating these employees for overtime or minimum wage provisions are governed by the Fair Labor Standards Act (FLSA).
Commission and bonuses are the other major type of direct compensation. Commission-based pay is most common in sales and is paid out as a percentage of goals met (or quota). Typically, the amount of commission paid increases as the goal increases. Commission goals can be based on different things. For example, some sales goals are based on revenue. If a salesperson does $100,000 worth of new business at a commission of 5 percent, then the salesperson will take home $5,000. Commissions can also be based on gross profits or profit margins, where the higher you sell a product or service for, the more money you make. There might also be commission fees – called placement fees – that pay out fixed amounts for each unit sold.
There are also many ways to structure commission as part of overall compensation. Examples include salary plus commission, in which the employee makes both a salary and commission as part of overall compensation package; straight commission, in which the employee makes only commission; residual commission, in which the employee continues to earn commission on ongoing accounts; graduated commission, in which commission increases at higher sales volumes; and variable commission, which is a mix of commission types. Each of these types of commission has its proponents and detractors. Which is right for a business depends on the specifics of the individual business, its industry, and goals.
Bonuses are a little different. Although also a form of variable pay, bonuses are applicable to more than salespeople. Year-end bonuses are a common example where employees are paid a sum, or a percentage of a sum, based on the performance of the business, the individual meeting established incentive-based goals, or at a manager’s discretion. Bonuses can be offered more frequently, such as quarterly. There are also spot-bonuses, which reward performance at the discretion of management in relation to a specific time-frame or project or achievement. Bonuses can also be a shared incentive split across an office, department, region, location or team.
Is a bonus the same as incentive pay? Not exactly, although a bonus is arguably a type of incentive when tied to established metrics such as KPIs, MBOs, or OKRs for measuring goals related to performance. The point of incentive pay is to encourage employees to achieve a higher standard. Bonuses can be tied to metrics too, which is when they are a type of incentive pay, but bonuses can also be paid without any quantitative performance measurement, such as in the case of a Christmas bonus or when management decides to reward employees spontaneously after a profitable year, successful event or stressful period. Generally, we say that bonuses are backward-looking while incentives are forward-looking. In other words, bonuses reward past actions while incentives encourage future results.
Base Pay vs. Total Compensation Statement
Arguably, the most practical way to communicate compensation to employees in a way that will make the most sense to them is as a total compensation statement or employee rewards report that separates base pay from commission-based pay, bonus pay, other forms of variable pay, company contributions to benefits and other benefits of monetary value. This helps employees know what they can count on with every paycheck, what compensation has to be earned through performance and the cash equivalent value of benefits and other rewards provided by the company.
For an example, see the sample total compensation report below from PayScale’s Insight Lab product:
At the end of the day, what matters when it comes to the different types of compensation is how you communicate it to employees. Ideally, you want to present every new hire with a summarized report of their compensation along with your company’s compensation philosophy. In progressive organizations, this conversation is led by the employee’s direct manager, who is also the go-to resource for questions about compensation and career advancement as the employee matures with the company. This requires training managers on compensation, including how to talk to the different types of compensation, how to explain the total compensation statement and how to answer questions about variable pay and benefits.
Although many organizations have yet to achieve a truly progressive and transparent approach to compensation management, research on compensation best practices has shown that the reward for doing so is increased employee engagement, reduced turnover and a more compelling employer brand.