How Compensation is Actually Determined at Most Companies

Lars Lofgren Avatar
Disclosure: Our content is reader-supported, which means we earn commissions from links on HR Advice. Commissions do not affect our editorial evaluations or opinions.

Aside from factoring in federal and state minimum wage laws, there’s no cut-and-dried method for determining employee compensation. That means that every company has to figure out how much to pay each of its employees without much external guidance.  

But that doesn’t mean a company shouldn’t have its own protocol for setting compensation. If you don’t have a predictable way to determine compensation, your company will eventually get into legal or financial trouble. 

So how do companies typically figure out the salary, employer-sponsored benefits, and extra pay for a specific role?

It depends. You can either set compensation according to the person you hire, the position you’re hiring for, or a mixture of both.

Let’s dive in. 

How Compensation is Determined for Individuals

Compensation can feel like a tricky, highly variable sum to nail down. 

But it doesn’t have to be. If you know the factors that play a role in determining compensation for individuals, you can pick the ones that make the most sense for your company. 

Then you can develop a method for objectively determining compensation according to each factor. 

Let’s take a closer look at the factors that can affect how you compensate an individual.


Experience is king when it comes to hiring the right person for a position. The years of relevant work experience a person has often play a role in compensation. 

And for a good reason! 

When you hire someone with just a few years of experience—or none at all, yet—you’re taking a risk. You might get an innovative worker who breathes life into your business. Or you might get a person who makes frequent and costly mistakes. 

Because of this risk, employees on the lower end of the experience scale tend to earn lower compensation. Wages might start out at $27 an hour for a first-year nurse, for example, and jump up to $30 an hour after the first year and $40 an hour after five years of experience. 

Experience can affect benefits, too. You might decide to offer: 

  • Lower health insurance premiums to employees with more experience 
  • Increased or decreased retirement benefits based on experience, which is allowed by federal law—but keep in mind that due to the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code, you’ll need to follow certain federal standards if you offer retirement to your employees
  • Additional hours of PTO for employees with more experience
  • Standard, federally mandated time-and-a-half overtime pay for employees with fewer years of experience and double overtime for employees with more than five years of experience 

Just make sure that you follow all the health insurance, retirement, overtime, and PTO laws that apply both to your state and to the US government. 

We also recommend putting your salary and benefits scale in writing, having your legal team review it, and making it easy for your employees to access. 

When employees can see how much their salary and benefits will go up with each year of experience in a particular role, they’ll have clear benchmarks to work toward.

Years of Service

If you’re committed to being an employer that people want to work for, you’ll reward employees for the time they spend at your company. Maybe this looks like increased PTO, a cash bonus, or equity in the company. It’s up to you!

Years of service can often play a role in retirement benefits, for example. Some employers offer increased retirement benefits for employees who serve at their company for the five, ten, fifteen, or twenty years before their retirement. 


Performance reviews and pay increases go together like apple pie and ice cream. 

Companies should conduct performance reviews at least once a year. Twice a year is even better. Just make sure you can afford to provide pay increases at the same time as those performance reviews.

In the age of texting, emailing, and workflow management systems, performance reviews can feel outdated. But we find it helpful to think of them as coaching sessions to help your employees feel supported in meeting their goals. 

Special Skills

Many employers reward their employees with additional compensation for valuable, specialized skills. 

Let’s say you’ve recently hired two new team members to fill two identical sales positions for your investment company.  

These employees both have two years of experience. Both hold a bachelor’s degree in finance. Both are skilled at interpersonal communication and work well under pressure. 

But only one has traveled the world delivering keynote speeches at conferences and conventions. This employee even gave a TEDx talk on creativity in finance that went viral.

If you plan to leverage this new employee’s amazing skill, it’s worth offering additional compensation. 

Level of Education

It takes years—and usually some student loan debt—to earn an educational degree. Paying more for a higher level of education reflects the blood, sweat, and tears behind each degree. 

So let’s say a role in your company requires a bachelor’s degree. You could hire someone with a bachelor’s degree and pay them a wage closer to the lower end of your salary band. But instead, you end up hiring a person with a master’s degree.

That degree represents specialized knowledge and, in many ways, extra experience. It makes sense to offer a higher salary to a person with a master’s degree rather than a bachelor’s alone. 

And if other team members discover they, too, can earn a higher salary with a master’s degree in a relevant field, they may be motivated to gain more education. 

A team of highly educated + experienced people = a healthy company. It’s a win-win for everyone. 


A cost-of-living adjustment (COLA) is additional payment to help your employees afford basic needs, like food and housing. 

But doesn’t the paycheck cover that? 

Take a look at these two scenarios: 

  • Sally, a law clerk for a firm in Tulsa, Oklahoma, gets paid $60,000 a year, or about $4,000 a month after all the typical deductions. She buys a 1,500-square-foot house for $179,000. The mortgage costs $1,089 a month. A gallon of milk costs $4.31. A gallon of gas costs $3.28. 
  • June, a law clerk at a firm in Juneau, Alaska gets paid $60,000 a year, or about $4,000 a month after all the typical deductions. She buys a 1,500 square-foot-house, which costs $500,000. The mortgage is $3,272 a month. A gallon of milk coasts $5.25. A gallon of gas costs $4.19. 

Sally and June do the same job and are paid the same salary. But one of them lives in a town with a much higher cost of living than the other. 

Sally easily affords groceries, heads out on road trips every summer, and is building up a nice nest egg.

June can barely afford to buy food after she pays her mortgage each month. 

Would you make sure she could afford to live in Juneau by giving her a COLA? 

We sure would. 

If your employees must live and work in an area with a high cost of living, you should absolutely factor that into each employee’s salary. The COLA should be the same for all of your employees and should rise with inflation

How Compensation is Determined for Specific Roles 

Just as with determining compensation for an individual, there are many things that affect how much compensation comes with a specific role. Here are the factors that get considered the most. 

Job Title

A person’s job title can greatly affect their salary. That’s because the higher you go in a company’s hierarchy, the more responsibility you carry. 

The increase in compensation reflects this. 

For an example, we’ll look at the role that editorial staff do at a publishing house. 

At the lower end of the hierarchy, you have editorial assistants. Editorial assistants spend their days taking meeting minutes, reading the slush pile (submissions from literary agents), and helping editors stay organized. 

While this work is important, the stakes are low-ish. And editorial assistants make between $40,000 and $50,000 a year

If an editorial assistant progresses to the role of assistant editor, she’d have more responsibility. This could include helping mid-level editors communicate with authors, writing marketing copy for book jackets, and making sure the book goes to print on time. 

Higher stakes means (slightly) higher pay. Editorial assistants might make $50,000 to $60,000. 

An editor who works directly with authors to develop books and prepare them for publication—the ultimate goal of publishing houses—can expect to make $70,000 to $80,000 a year. 

And so on. In almost any company structure you look at, roles on the lower rungs of the ladder pay less than those higher up.

Tasks and Responsibilities

The more tasks and responsibilities an employee takes on, the more they should get paid. 

End of story. 

Sometimes these responsibilities and tasks correspond with a higher job title, but not always. Look at data scientists, for example. Even entry-level data scientists can make $79,000 a year.  

But think about primary care physicians versus neurosurgeons. Primary care physicians go through about 10 years of education and training. They make around $200,000 a year. Their main role is to provide preventive care for people of all ages. 

While they treat many common medical issues, primary care physicians don’t operate on people’s brains. 

A neurosurgeon, on the other hand, is tasked with going in and fixing problems with the brain and nervous system. To become a neurosurgeon, a person must study and train for 14-16 years after high school. 

It’s no surprise that a role with this level of responsibility pays a starting wage of $300,000 annually. Highly experienced surgeons making closer to 1 million dollars a year. 

Required Education

Another reason neurosurgeons make so much money? They have to go through almost two decades’ worth of school just to start a career in neurosurgery. And a higher education level means a bigger paycheck. 

But this isn’t limited to college education. To become an underwater welder, for instance, you must: 

  • Earn your high school diploma or GED
  • Earn a welding certificate and welding experience from a trade school
  • Pass a physical exam 
  • Gain a commercial diving certification from a diving school

With this education, you can get an entry-level role as an underwater welder. Pay ranges from about $50,000 to $70,000 for first-year underwater welders. Once you have enough experience, you can head out into the deep sea for a higher paycheck—and higher risk. 

Required Experience

If you want to be a deep-sea diver, you can’t hop right into a saturation diving role right out of the gate. Saturation diving involves living and working deep underwater for days or weeks at a time. 

It also pays very well—think $500,000 a year for the top 10%.

But first, you need those welding and diving certifications plus at least a few years of experience welding closer to the shore. 

Salary Benchmarks

Salary benchmarking is the process of comparing the salary you pay an employee with the salary your competitors pay their employees for the same role.

It’s a key way to make sure you’re paying your employees what they’re worth. If you don’t keep up with market trends when it comes to compensation, you could lose your top talent to a competitor.

Salary Bands

A salary band is a compensation range for a specific role within a company. It sets the boundaries for what an employee can make after factoring in things like education, experience, and job title.

For instance, you could establish a salary band of $90,000 to $130,000 per year for an IT manager at your manufacturing company. The candidate you hire will receive pay somewhere within this range. 

It all depends on how much experience, education, and skill they have. 

Job Market Trends

Understanding the current job market is helpful when you’re putting together a salary for a role. Research the job market trends in your industry and in general. Is there a shortage of workers for the role you’d like to fill? 

If so, you might need to make the compensation package extra appealing. 

It’s worth checking the employment projections put out by the U.S. Bureau of Labor and Statistics to keep your finger on the pulse of the job market. 

Be Objective When Determining Compensation 

Compensation is a touchy subject. If bias or favoritism looks like it crept in—even if it didn’t—you can find yourself in trouble with your employees and the law. 

That’s why it’s important to be as objective as you can when you’re determining compensation. Take a look at which factors you’ll use to put together your salary scale. Develop a method for figuring out objective compensation for each one.

For example, you might assign years-of-service raises as follows: 

  • 2.5% raise after two years
  • 5% raise after five years
  • 7% raise after seven years

These are completely random numbers, of course, and you’ll need to figure out which percentages work for your company. In other words, make sure your budget can handle the percentages you choose. 

If you want to provide extra compensation based on special skills, you have to tread carefully. Special skills are hard to analyze objectively. Here’s how to keep things fair and transparent:

  • Outline the special skills that can earn your employees extra compensation 
  • Provide an exact number or range for how much additional compensation they’ll get for each special skill
  • Detail the steps an employee needs to take to prove proficiency in the skill

As always, make sure that you can afford the extra cash you plan to pay for these special skills.

To provide raises based on a performance review, have your manager fill out an employee review form for each employee. Ask the manager to categorize the employee’s overall performance level according to a rating scale. 

Each rating could then correspond to a raise percentage:

  • 1: Poor—0% raise + an action plan/discussion about whether the position is a good fit
  • 2: Unsatisfactory—0% raise + an action plan may be needed to support the employee in improving their performance
  • 3: Satisfactory—5% raise
  • 4: Good—7% raise
  • 5: Outstanding—10% raise (and a promotion!)

Once or twice a year, when your company does another round of performance reviews, you can compare the new form with the old one. This helps you measure how an employee’s performance has evolved over time and determine which rating—and therefore, which raise—to give. 

Above all, it’s crucial that you outline the procedures and policies for determining compensation in the employee handbook. Make sure you give this document to new hires and alert employees every time there’s an update. Ensuring that compensation is fair and transparent can save you a lot of trouble down the road. 

Unfortunately, it’s impossible to be 100% objective in anything. But when you’re determining compensation, you want to be as close as possible. 

Now that you know how to determine compensation, you’ll need to manage it with a rock-solid payroll budget. Read our guide to creating a payroll budget that keeps things simple yet structured for you and your team.

Build and Grow right from your Inbox

Scroll to Top