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How to Set Pay for Contractors

During an economic downturn, businesses look for ways to reduce or control expenses. One of those ways is to utilize contractors instead of hiring full time employees. This may be due to a hiring freeze or because contractors put less of a burden on the organization as they don’t get benefits. Contractors are also a popular choice for short-term projects, projects requiring expertise that the business doesn’t have, or for projects with an unclear duration where the organization is unable or unwilling to commit full-time staff.

Typically, an organization looks to hire a contractor when someone asks the question “can we get a contractor to do this?” You might be in need for a Salesforce administrator, a content writer, an HRIS systems analyst, or a tax accountant. Whatever the position, an organization new to hiring contractors may not know how to budget for it.

So how do you set pay for contractors? How does the pay for a contractor compare to your regular employees, especially if the contractor is working alongside your employees or doing a similar job?

Let’s break it down.

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Understanding the different types of contractors

First, it’s important to understand how a contractor is defined. Contractors are not employees. Typically, a contractor is an independent operator or freelancer who will perform services for you but is not under any obligation to abide by your company’s rules for employees. An independent contractor is independent; you stipulate what work you want performed and they deliver that work according to the contract. However, the line can be blurry and some organizations (famously Microsoft) have gotten into legal trouble for treating contractors like employees without the benefits.

Not sure how to tell the difference between a contractor and an employee? Check out the IRS’s guide to independent contractors versus employees.

Many businesses seek contractors as temporary additions to the team and turn to staffing companies for help sourcing talent. Staffing companies can source full-time employees and temporary workers as well as contractors. Different staffing companies specialize in different areas, so you might look for one with knowledge of your industry or the type of talent you are looking for. For example, you might need creative talent, marketing talent, technology talent, finance talent, office administrative staff or manual labor. Look for a staffing agency that specializes in what you need.

A company can also work with a freelancer directly. Many freelancers have business websites or a social media presence where they can be found and contracted for a specific project or scope of work. There are also websites like Upwork that consolidate profiles from freelancers from around the world and act as an intermediary between the contractor and the businesses.

A contractor can also be a private company that wins a bid for a complex project and provides all the labor and management of resources to execute. This process usually involves some kind of Request for Proposal (RFP) and a contract agreement defining the scope, timeline, and cost of the project.

Contract projects can be paid for as a fixed bid, as an estimate of time and materials (T&M), or through a managed services agreement (MSA). On a fixed bid, the contractor owns the risk for delivering satisfactory work according to the scope, budget and timeline. With time and materials, you will be billed for all time and materials to complete the work to your satisfaction. With a managed services agreement, you will have control over the daily work of people provided by a contracting agency until your project is complete.

So now that we know what they are and where to find them, let’s talk about how to set pay for contractors.

How to set pay for contractors

As has already been established, contractors are not employees. A contractor is a private business that will bill you for their services according to a fixed project fee or hourly rate. If you hire a contractor through a staffing agency, the staffing agency will pay the contractor’s pay rate and charge you a bill rate that will include administrative and recruiting costs on top of the pay rate. Many staffing companies also provide benefits options to contractors, employing them as a W2 for the duration of the contract. Contractors employed as 1099 will incur a higher pay rate but won’t be eligible for benefits.

Regardless, you still have to figure out a budget. To roughly estimate the hourly rate of an individual, you can convert the full-time salary for the position you are hiring into an hourly rate. To get the full-time salary, you can use PayScale’s market data, controlling for compensable factors such as location, industry, years of experience and special skills. To arrive at the hourly rate, divide the annual salary by 2080, which is the approximate number of hours worked in a year.

However, you should be aware that this calculation only tells you the approximate pay rate of the contractor. It does not tell you the bill rate. To arrive at the bill rate, you must apply a multiplier. The multiplier will vary depending on the position. A multiplier of 1.5 the pay rate is a good starting place, but location, industry, the level or seniority of the position, and other variables can impact this amount. It also depends on whether the contractor is W2 or 1099. A 1099 contractor’s bill rate may be double the hourly pay rate.

If you are working with a staffing agency to source and deploy a resource, they can provide insight into market rates for the position you are seeking, especially if it is a job they commonly staff. If you are a hiring manager, you might also go to the internal recruiting or procurement team in your organization as they may already have staffing agencies they work with and can provide guidance on what to budget for a contractor.

One thing to be aware of in setting pay for contractors is that the duration of the contract affects the rate. The shorter the project, the more expensive the contractor might be to employ. Some staffing companies have minimums for deploying contractors and prefer long term assignments of six months or more. If you need a contractor for a very short duration, you may need a freelancer or go to a temping agency that works short term assignments.

The other thing to be aware of is conversion fees. In many cases, organizations employ contractors to kick off a new project only to realize that they need to maintain a program or have a lot more work for the contractor to do. If the contractor is a good fit for the team, it can be possible to convert the contractor to full-time employment, assuming the contractor is interested in full-time and not a career consultant. Some staffing agencies charge fees for conversion, especially if the contractor has not yet completed the terms of the contract, but the stipulations vary by agency.

Best practices for paying contractors

Given that contractors work alongside your full-time employees and might become employees if you end up converting them, it is important to pay them fairly. Just because someone is a contractor doesn’t mean that their skills are less valuable or that they are less part of the team. If you have contractors engaged for a long period of time, you don’t want them to learn that they are being paid less than the “real” team members, especially if they are high performers.

It is also possible to pay contractors more than your full-time team. This is acceptable if you are hiring experienced consultants on a contract basis to provide strategy and direction or expertise to help train your full-time staff. This can be worth the high rate as it can save your business the expense of having to do work over or extend the amount of time needed to complete a project because you don’t have the right knowledge or resources internally, especially if the project is business critical or complex.

As is true with all jobs, you want to pay accurately for the position. Location, skills, years of experience, and education can all affect market rates. If you want a contractor with specific expertise, especially rare skills or skills uncommonly found in combination, you might have to pay more.

However, there are times when a very high rate is not the right solution. You might find that you are looking for a purple squirrel and have to redefine your requirements, potentially bringing on multiple contractors with complementary abilities rather than one overstuffed position. If you do find a mythical candidate possessing skills not usually seen in combination, make sure you compensate them appropriately. PayScale’s Differentials Engine can help you assess how compensation should be adjusted when combining hot or hard to find skills.

In summary, the way to set pay for contractors is to work with the contractor directly or with a staffing agency to determine the hourly bill rate. Expect this rate to be higher than the rate that you would pay to an hourly worker that you employ full-time. If you are working with internal procurement or an outside staffing agency, let the recruiter provide insight on the pay rate. To get a rough estimate, you can use PayScale’s compensation management software to determine what an appropriate salary would be if you were to employ the position full-time, calculate the hourly rate by dividing by 2080, and add a multiplier of 1.5.

Amy Stewart
Sr. Content Marketing Manager at PayScale
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