The 4 Basic Compensation Structures and When to Use Them

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Compensation structures define how companies pay their employees. Within a compensation structure are clear guidelines for setting salaries, bonuses, benefits, commissions, and any other type of compensation the company provides.

Compensation needs to be clear-cut and well-defined rather than subjective, which is what compensation structures accomplish. Without them, a company risks pay inequities, high turnover rates, employee dissatisfaction, and potential compliance issues.

1. Market-Based Compensation Structure

Market-based compensation structures use compensation benchmarking to determine salaries based on market data. In other words, companies using a market-based compensation structure use salary data gathered from other companies to figure out fair salaries for their employees.

Compensation benchmarking is the actual process of comparing a company’s salaries with market salaries. From this information, your company can learn whether it’s paying an amount that workers would consider fair for their role. 

It’s also a good way to decide if your company’s pay is competitive in the market. Say you like to aim for higher-than-average pay for your workers, but market data for most of your roles is right in line with what you currently pay. That’s a sign that you may need to increase salaries for those roles to remain competitive. 

A market-based compensation structure looks outward to help inward pay practices, while some compensation structures compare salaries internally. Although the latter is certainly helpful for maintaining pay equity within your company, it won’t tell you anything about how your pay compares to your competitors’ pay.

The downside is that market-based compensation is only as useful as your data is accurate.

Use data from five years ago, and you’re not going to learn much about what you should be paying employees today

Annual updates, annual updates, annual updates. I can’t stress it enough. Keep your market data updated annually when possible if you’re using a market-based compensation structure.

Some positions that aren’t as widely recognized may not have frequently updated data. In that case, compare the most recent data for that role to more current data for a similar role to get as close as you can to a number that makes sense.

Also, keep in mind that market data fluctuates by location. Ideally, you’ll want to use data that’s geographically relevant to your company. Pay for a position in New York City will probably be much higher than pay for a similar role in a suburb of Columbus, Ohio, for example.

Or, do what I do and benchmark all salaries based on a single, high-paying area. Not surprisingly, NYC is my go-to.

You’ll also need to consider that the benchmarking tools you use will probably have some disparities in data. Be mindful of where you source your data from. Personally, I like HR-reported data, as it tends to be more accurate than web-scraped or employee-reported data.

If you’re in a highly competitive industry with quickly evolving roles, I suggest using a market-based compensation structure to attract and retain highly qualified workers.

2. Grade and Range Compensation Structures 

Usually referred to as graded compensation or pay ranges, a grade or range compensation structure defines minimum and maximum salary amounts for a specific position. 

Although there are different types of pay grade structures, traditional pay grades usually have relatively narrow scales, but there might be multiple pay grades for one type of role.

For example, a logistics coordinator’s pay grades might look something like $50,000-$53,000 for pay grade 1, $53,001-$56,000 for pay grade 2, and so on.

The idea here is that entry-level or newly hired workers in that position earn a lower amount within their pay grade tiers than more experienced workers in that role, but everyone in that position has the potential to work their way up into different pay grades.

By narrowing the salaries within each grade, workers don’t scale up too quickly. Instead, the company can balance raises with regulated pay. This tends to work best in companies with several employees and positions, as each position has defined grades to individualize pay and incentives for each worker’s performance. 

On the flip side, that definition also creates a lot of admin for HR. Updating pay grades can take more time and attention than compensation structures with broader salary ranges. 

3. Broadband Compensation Structure

A broadband compensation structure is a particular type of grade-based structure that defines pay grades with wide gaps between the lowest and highest points. This is in contrast to typical grade and range compensation, which tends to define narrower pay ranges.

To compare, a typical level-2 pay grade for a software developer might be $70,000 to $80,000, while a company using a broadband compensation structure might make the range $60,000 to $90,000 for a level-2 developer.

What’s the advantage here?

Broadband compensation leaves a lot of room for employees to work their way up within their roles. It can encourage professional development and skill-building, especially for workers who are early in their careers.

Broadbanding also takes some of the complexity out of structuring pay grades. With broader salary bands, there are fewer pay grades for HR to manage. 

On the other hand, broadband compensation can be challenging for large companies with several employees, which may need more well-defined salary ranges to manage bonuses, raises, and promotions. 

Compensation analysis can also become tricky. Broadbanding lumps similar roles together into one salary band, so it won’t be as straightforward to compare those roles and salaries to more specific market data. 

With that said, broadband compensation is usually best for smaller companies with less than 100 employees or only a few different positions. 

Larger companies wanting to use broadband compensation should consider splitting their bands into different levels for executive, managerial, and non-managerial positions, as executive positions typically don’t need as much room to progress and, therefore, need fewer salary bands.

4. Step Compensation Structure

Step compensation structures provide increased pay based on a specific metric. 

Usually, these structures are based on the time worked for a company, like $50,000 to start, $55,000 after one year with the company, and $62,000 after five years. Companies typically create a step compensation system that increases pay in specific increments, like every two years, three years, or five years.

Step compensation is relatively easy to establish and manage, too. Annual compensation reviews can keep each salary step on track without much additional work.

However, employee performance can get overlooked with a step compensation structure. With such clear-cut numbers in place, there’s not much wiggle room for bonuses and other performance-based incentives for top performers, potentially leading to an unmotivated team.

Therefore, a step compensation structure mostly benefits newer companies as they increase revenue. By the first bump in pay after a year, a company should be in better shape than when they were just starting out, allowing them to afford the salary increase. By years three, five, and beyond, the company’s revenue and payroll budget should continue increasing if all goes to plan. 

After around the five-year mark—or earlier, if the company has experienced a lot of growth—it may be best to switch to a different compensation structure that allows for more flexibility with raises and incentives.

Choose the Right Compensation Structure for Payroll Success

The age and size of your business are two of the most important factors to consider when choosing the best compensation structure. 

Step and broadband compensation generally work well for small, newer businesses, but large organizations need something a bit more scalable, like pay grades, and competitive, like market-based compensation. 

Although sticking to one compensation structure from the start of your company sounds ideal, it doesn’t always work. As your company goes through growth spurts, it’s natural to transition to a compensation structure that aligns better with current and future goals.

Don’t ever feel pigeonholed into one structure for eternity. A good HR team will know when and how to pivot to manage compensation successfully.

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