Benefits and perks get a ton of airtime on HR blogs. And employees will indeed be looking for good health insurance, PTO, and retirement plans. It doesn’t hurt to throw in a paid gym membership and DoorDash passes, too.
But if you’re not paying employees the right amount of cash in addition to these benefits, they don’t matter.
Cash is king, after all. In the HR world, it’s called direct compensation.
Confused about what counts as direct compensation? We’ve got you covered.
What is Direct Compensation?
Direct compensation is the cash that you pay your employees as part of their wages, salary, bonuses, overtime pay, or commissions. It’s the money that your employees get in the form of a check or bank transfer.
It’s the opposite of indirect compensation, which is everything else an employee gets in return for their work.
Direct Compensation vs. Indirect Compensation
Direct compensation is cash paid directly to an employee. Indirect compensation is still money spent on your end, but not directly to your employees. Instead, it encompasses things like health insurance, equity, and life insurance.
Here’s a scenario to help define these two sides of the same coin.
Let’s say you’ve just started a small marketing and advertising business. You hire two full-time copywriters, an SEO specialist, a graphic designer, and a content editor.
Because you want to attract and retain the best talent there is, you offer competitive wages to each employee. You pay them every month on the 1st and 15th by directly depositing the money into their bank accounts.
This is direct compensation.
Along with direct compensation, you offer health insurance, a retirement savings plan, and paid time off. These forms of compensation cost you money, but they aren’t cash in your employees’ hands.
Instead, these benefits help your employees enjoy mental and physical wellness—along with peace of mind for the future.
This is indirect compensation.
Taken together, they make up your employees’ total compensation.
Direct Compensation vs. Take-Home Pay
Direct compensation and take-home pay are almost the same thing. Direct compensation is the total wages your employees earn before you set aside a cut of each check for taxes, medical premiums, and other payroll deductions.
What’s left after these deductions is your employee’s take-home pay. In other words, it’s the money that’s readily available for your employees’ bills, groceries, and other expenses.
What is Included in Direct Compensation?
From salary and wages to pay differentials and fringe benefits, there are many forms direct compensation can take. Let’s take a look at each one in detail.
Salary
Salary is the amount of money you pay a non-hourly employee for the work they do. Job postings often include a salary range, whether it’s written out in a monthly or yearly format.
Let’s say an engineer named Malik is looking for a remote position that allows him to work from home. He sees two potential roles that stand out.
One lists a salary range of $80,000 to $100,000 per year. The other is only partially remote but offers a salary range of $100,000 to $120,000 a year.
Malik fits all the main requirements for both job postings, so he decides to apply to both.
He ignores the postings that leave out the salary range altogether even though there are several that are fully remote.
To Malik, the lack of transparency about the salary range is a red flag. And he’s not alone.
Salary is deeply important to job applicants. A study conducted on LinkedIn showed that job applicants are 91% more likely to click on a job posting if it lists the salary range.
And in a growing number of states, employers are required to post this information.
But salaries are more than just a random number. Each company must figure out what salary it can afford to pay its employees.
Take a look at your finances. Create a mock payroll budget. Research the salaries your competitors offer. These steps can help you determine the salary for each position in your company.
Or, you can choose to pay all (or some) of your employees an hourly wage.
Wage
Unlike a salary, a wage is paid by the hour. Take the federal minimum wage, for example, which is (an appalling) $7.25 per hour. Or the state minimum wage in California, which is a much-better $15.50 an hour.
Including an hourly wage range in a job description has the same benefit that adding a salary range does. It lets job applicants know how much they can expect to get paid. A posting I saw the other day for an aircraft maintenance technician listed a verified wage range of $41-$61 per hour.
If I were an aircraft maintenance technician, I would 100% apply for that role over one without a wage range.
Keep in mind that if you do pay any of your employees an hourly wage, you’ll need to follow the laws set out by the Fair Labor Standards Act (FLSA). This includes paying overtime anytime an employee clocks more than 40 hours per week.
This brings us to our next form of direct compensation: pay differentials.
Pay Differentials
A pay differential is any extra monetary payment that you provide an employee in exchange for a special circumstance. If you’re in desperate need of medical technicians, you might offer a signing bonus of $2,000 after one month’s work—on top of the regular wage of $20 an hour.
This is a pay differential.
Other examples of pay differentials include extra pay for things like overnight and weekend shifts, hazard pay, on-call pay, and paid holidays.
Commission
Some employees are paid a base wage or salary plus commissions.
Take a real estate agent, for example. Some brokerages pay their real estate agents a base salary plus commissions on each house the agent sells.
Other brokers hire real estate agents as independent contractors, which allows brokers to offer commissions-only wages. These commissions still count as direct compensation.
You’ll find commissions-based pay in a variety of fields, from finance and auto sales to insurance and advertising.
Variable Pay
Variable pay is any type of compensation that fluctuates depending on a specific circumstance. (And yes, pay differentials are a form of variable pay.)
A nurse might work a night shift and earn a hefty shift differential one week but avoid night shifts for the next three weeks. The shift differential is the variable pay.
Or, a real estate agent might earn a large commission on a luxury home in June but sell only lower-cost houses for the next two months. This unpredictability is what makes a commission count as variable pay.
Overtime pay, holiday bonuses, performance bonuses, and profit sharing are other types of variable pay.
Fringe Benefits
Fringe benefits can be direct or indirect. Health insurance is an indirect fringe benefit because you don’t directly pay your employees money to use for their medical bills. Instead, you foot part of a premium on their behalf.
A direct fringe benefit, on the other hand, results in more money being added to an employee’s paycheck.
Take housing or cost-of-living adjustments, for example. If the owner of a company offers employees an extra $1,500 to help pay for housing costs, it’s a direct benefit.
So is a cost-of-living adjustment (COLA) to help employees afford to live and work in a city with a high cost of living.
What Factors Impact Direct Compensation?
From experience and education to working conditions and performance, several factors impact direct compensation. We’ll take a quick look at each one.
- Experience: When an employee comes on board with plenty of work experience in your industry, they can hit the ground running. This means less training and onboarding work for your existing team. A confident, efficient employee is a valuable asset, which translates to higher compensation.
- Skills: An employee with skills that go beyond the typical job requirements is something companies should treasure. If you hire a graphic designer with an eye for branding who can code with the best of them—and deliver a mean PowerPoint presentation to boot—why wouldn’t you offer them a higher wage?
- Education: Each educational degree a person earns reflects years of hard work, student loans, and heightened expertise in a field. Direct compensation should reflect this.
- Responsibilities: Higher levels of responsibility often come with a bigger paycheck. A senior manager at a consulting firm, for example, usually earns more than a field consultant.
- Supervision Required: A new employee at a company usually requires extra supervision from a supervisor or manager. Because of the extra oversight, compensation may be less, but this typically changes as the employee gains more autonomy within the role.
- Working Conditions: All employees deserve as safe a work environment as possible, but if a particular role comes with risk baked in, an employee’s compensation should reflect this. (But it often doesn’t—which is a post for another day.)
- Seniority: The longer a person spends at a company, the more years of company-specific experience they have. This seniority reflects countless hours of hard work and loyalty to a company—and it comes with a bigger paycheck.
- Performance: Many employers conduct routine performance reviews to analyze each employee’s strengths and weaknesses. Strong employee performance often leads to a rise in direct compensation.
- Cost of Living Adjustments: If your employees must live and work in Hawaii or Massachusetts, both of which are notorious for their high cost of living, the employee’s direct compensation should reflect that. You want your employees to afford housing and groceries, after all.
3 Tips for Controlling Direct Compensation Spend
Payroll is usually a company’s biggest expense. It’s the HR department’s responsibility to balance employee satisfaction with the company’s financial stability. Here’s how you can strike a fair balance between the two.
1. Create a Payroll Budget
Setting up your payroll budget is easier than you might think. You’ll need five pieces of information for each employee on your payroll:
- Name
- Job title
- Employment type—full-time equivalent (FTE), contractor, part-time equivalent (PTE), etc
- Department
- Annual salary or wages
If you’re just starting out as a business owner or have recently decided to hire your first employee, you can jot down the amount you think you’ll be able to pay an employee.
Otherwise, just check your payroll software to see how much each employee currently gets paid per year.
(Side note: payroll budgeting is a simple way to keep your finances in check, but payroll processing requires powerful software. Don’t make the mistake of processing payroll with a spreadsheet!)
Just make sure you include all forms of direct compensation in the salary/wages section. This includes variable pay, bonuses, commissions, and pay differentials.
Next, tack an extra 25% on each employee’s annual salary.
Why, you ask?
To cover the indirect compensation, of course! Right now, there’s no need to keep track of how much the benefits, taxes, and social security expenses will cost for each employee. The 25% rule covers most forms of indirect compensation—and then some.
So for example, if an employee named Claudia makes $80,000 a year in direct compensation, add an extra $20,000 to her salary. This gives you a more accurate picture of what you’ll spend to pay Claudia for her work.
You can refine the details later on if you need to. But even a basic payroll budget like this will give you an idea of how much you’ll be spending, allowing you to make changes as needed.
Download our free template and learn more about setting up a company budget in our guide to creating a payroll budget.
2. Match Compensation Philosophy with Your Budget
When you’re figuring out what to pay your employees, you have to make some tough choices. Should you lead the market by paying your team a higher wage than your competitors? Or would it be more financially wise to lag the market, paying what used to be standard but isn’t quite competitive anymore?
Or you could aim for the middle ground, alignment, which means meeting the job market where it is right now.
Each philosophy comes with its own challenges. Overpaying people can make you an attractive employer to work for, but it might be unsustainable in the long run. This could lead to layoffs, pay cuts, and other disappointments down the line.
If you underpay people, on the other hand, you might find it challenging to attract and retain top talent.
3. Enforce Salary Ranges
Once you know how much you can afford to pay an employee for a particular role, create a salary range. You could say, for instance, that the developers in your company can make between $90,000 and $120,000, all forms of direct compensation included.
You won’t go below $90,000, but you also won’t go above $120,000.
No matter how much your manager might want to attract the best developer in town with his ideal salary of $150,000 a year.
Think of salary ranges as the guardrails that keep your budget from flying off a cliff.
Now that you know all about direct compensation, it’s time to figure out how to keep your indirect compensation spend in check.
