Just thinking about all the employer costs for employee compensation is enough to make your head spin. There’s payroll tax. State tax. Worker’s compensation insurance. Benefits like healthcare, retirement contributions, and PTO.
Long story short? It costs a lot of money to compensate each employee on your team. You could spend your entire workday trying to figure out the exact price of everything that you pay toward an employee’s compensation.
Thankfully, you don’t have to calculate any of that using the 25 percent shortcut.
Use the 25% Shortcut to Find Total Employee Cost
The 25% shortcut is simple.
To calculate how much an employee will cost you, all you need to do is add 25% to the cost of the salary or yearly wage you pay them. Creating a payroll budget using this rule is quick and easy.
Say someone makes a salary of $80,000 a year. Instead of adding up the price of childcare assistance, retirement contribution, health insurance, and all that, just calculate 25% of $80,000.
The resulting number—in this case, $20,000—is what you add to the salary and write down in your payroll budget.
It’s nearly impossible to calculate or predict the precise cost of healthcare, retirement, and other perks and benefits because they can fluctuate. Sticking to 25% is a safe bet.
True, some employees may go over this amount. But most will be safely under budget, evening everything out in the end.
We aren’t the first ones to use the 25% rule—not by a long shot. It’s a common HR strategy because it saves a ton of time when you’re setting up a payroll budget and estimating the cost of open roles.
When Companies Shouldn’t Use the 25% Rule
As with everything in life, there are some exceptions to this helpful tactic.
Here are a few of the most common situations where the 25% rule may not make sense:
- Really high turnover: If you have really high turnover and are constantly recruiting new people, the cost of employees is probably going to be higher.
- High overhead costs: Do you pay for a downtown office space? Do your employees need expensive technology to do their jobs? This high overhead can drive up the cost of compensating each employee.
- Lots of variable pay: If employees routinely make a ton of extra money by working shift differentials or putting in overtime hours, you’ll need to go higher than 25%.
If you’re in one of these situations, you can still follow the essence of the 25% rule. Instead of 25%, however, you can start with something like a 40% rule. As you get better data for what you’re truly spending on your employees, you can whittle this number down—or increase it, if necessary.
But most companies won’t need to do that. We actually started out using a 30% rule at our company. We wanted to be conservative. But it was way too high.
We are now at 25%, which is safely under budget every quarter.
Typical Employer Costs for Employee Compensation
You might still be fuzzy on what, exactly, that 25% rule is covering. Especially if you’re new to the business world or are hiring employees for the first time.
So we’ll break it down into three parts: direct compensation, payroll taxes, and indirect compensation.
Direct Compensation
When you pay an employee a salary or wage in the form of a paycheck, that’s direct compensation. It goes straight from your bank account to your employee’s hand (or bank account).
The most common types of direct compensation include:
- Base salary
- Hourly wage
- Commission
- Overtime
- Shift differentials
- Bonuses
Payroll Taxes
Every time your company earns revenue, you must pay taxes to the federal government, along with your state and local governments. Every time your employees earn compensation from your company, they must pay state and federal taxes, too. These payroll taxes support everything from Social Security and Medicare to public schools and road maintenance.
Here are the standard payroll taxes that you must pay:
- Federal unemployment tax: under the Federal Unemployment Tax Act (FUTA) and state unemployment taxes
- Social Security and Medicare: under the Federal Insurance Contribution Act (FICA)—employers pay half of the required amount and employees pay the other half
- Federal income tax: paid only by the employee—but employers are responsible for withholding and paying the taxes to the IRS each pay period
- State and local income tax: employers don’t pay these but many states require them to withhold and pay them on the employee’s behalf
Indirect Compensation
When you pay toward your employee’s retirement account, you aren’t paying the employee directly. But you are paying them money they’ll eventually get. And when you pay part of the employee’s monthly health insurance premium, you aren’t paying them money directly. But you are saving them money on health insurance.
These are both forms of indirect compensation, along with:
- Other forms of insurance, like dental and vision
- Professional development
- Paid time off (PTO)
- Paid parental leave
- Student loan repayment benefits
- Childcare assistance
- Equity/stock options
Costs Get Very Complicated, Very Quickly
You can imagine how challenging it would be to calculate every single one of these costs for every single employee in your company. Even with two employees, it’d be a challenge. Then you have to take variations in compensation into account, too.
Employee A might have more seniority than Employee B, meaning she gets more hours of PTO every year. Employee B might use the childcare assistance whereas Employee C does not. Employee C may have student loans you help her repay and a need for the childcare assistance benefit.
And so on.
That’s why it’s far easier to just use the 25% rule for payroll budgeting. You can set it up, tweak it as needed, and manage your overall budget much more quickly.
