Bonuses help organizations incentivize employee performance. Whether they surpass their sales goals or design a winning marketing campaign, an employee can receive bonus pay as part of their direct compensation package to reward them for outstanding work.
Bonuses are a type of variable compensation because they fluctuate and aren’t guaranteed on a specific timeframe or for a specific amount. An employee might earn a $5,000 bonus one quarter and nothing the next.
Still, bonuses are important to workers. They show that an organization appreciates the work an employee does, especially when the employee goes above and beyond their usual responsibilities.
But when a company pays bonuses, they need to understand how that extra cash factors into their payroll. Knowing what they cost or potentially cost and how to calculate taxes on them helps account for the additional cash in a payroll budget.
Use this guide to learn how to calculate bonus pay, like commission and sign-on bonuses, and bonus pay tax.
How to Calculate 7 Types of Bonus Pay
Commission
Commission is frequently used for sales-focused jobs. Commissions can come in several forms, depending on the scope of the role.
Flat commission, also known as straight commission, is a single rate given to an employee when they complete a sale. For example, Jennifer, a software sales rep, might earn $1,000 for every new software client she closes a deal with.
If she closes deals with five clients this month, she gets $5,000 ($1,000 x 5).
With residual commission, a company pays a residual fee, usually a percentage, for all current accounts they helped close.
If Jennifer’s company pays her residual commission, she might continue earning 2% for each of her clients remaining on the client roster each month. For a client paying $5,000 a month, Jennifer earns $100 ($5,000 x 0.02).
Revenue commission is based on the total amount of revenue a person sells, often as a percentage of the total sale.
If Jennifer sold a software package for $10,000 and earns 5% commission, she’d get $500 in revenue commission ($10,000 x 0.05).
Gross margin commission is based on the total sale minus any expenses involved in the sale. This commission is usually a percentage of the gross margin of the sale.
As an example, Jennifer sells the $10,000 software package but incurs $500 in travel, lunch meetings, and a demo to close the deal, bringing the gross margin of the sale to $9,500.
With her 5% commission, she’d earn $475:
$10,000 – $500 = $9,500.
$9,500 x 0.05 = $475.
Tiered commission is typically a percentage that rises as a sales rep hits new goals.
Say Jennifer starts with a 5% commission structure for up to $50,000 in sales. After she reaches that amount, she can earn a 6% commission up to $150,000, after which she maxes out at a 7% commission.
If Jennifer closed $50,000 in sales, she’d make a total of $2,500 in commission ($50,000 x 0.05).
This month, Jennifer gets another $10,000 in sales, putting her in the 6% commission bracket. She earns $600 on those sales ($10,000 x 0.06).
Performance Bonuses
Performance bonuses are awarded when an employee reaches a specific milestone or goal or goes above and beyond their typical duties.
Some organizations award spot bonuses for immediate recognition of excellent work. There are also team bonuses, milestone bonuses, attendance bonuses, and goal-based bonuses.
Really, companies can pay these out however they choose. Usually, they’re a flat amount rather than a percentage.
For example, Tim might receive a $1,000 bonus for working extra hours to cover his colleague’s shifts due to a family emergency. Or, an HR team could receive a $10,000 bonus to split amongst its members for completing performance and compensation reviews ahead of schedule.
A company can also choose a percentage-based bonus structure, which might come in handy for more measurable bonuses, like hitting some goals and not others.
Example:
An HR team’s maximum bonus was $10,000. They have five bonus-driven goals to meet by the end of the quarter, each paying 20% of their bonus.
That makes each goal worth $2,000 ($10,000 x 0.02).
HR met three out of five of their goals, giving them $6,000 ($2,000 x 3).
If the HR team has six people, each person gets $1,000 as their quarterly bonus ($6,000 / 6).
Sign-On Bonuses
Sign-on bonuses encourage top talent to accept a position. They’re usually paid as flat bonuses, like $2,500, but can sometimes be a percentage of the role’s annual salary.
For example, a $50,000 role with a 10% sign-on bonus offers the candidate $5,000 ($50,000 x 0.10).
However, some companies pay a sign-on bonus over a period of several months or after the employee works for a specific period to boost retention.
Example:
Say a company offers Dana a $5,000 sign-on bonus, paid over Dana’s first five full months of work. Dana would receive $1,000 for each of those five months ($5,000 / 5 months).
Alternatively, the company might hold the sign-on bonus until Dana works for three months. After completing her first three full months in January, February, and March, Dana earned her $5,000 bonus on April’s first paycheck.
Referral Bonuses
A referral bonus is paid to an employee when they refer a quality candidate to an open position within a company. The company usually pays the referral bonus when the referred candidate makes it to a certain point in the hiring process or when they get hired.
The referral bonus is usually a flat amount, like $500, paid for each qualifying candidate making it to the eligibility point of the process.
However, some companies might add to the bonus if the candidate has specific qualities they’re looking for, like a high level of education or an underrepresented background.
Example:
Van refers two candidates to his company to fill an open sales manager role. Van’s company pays $500 per referral, or $600 if the candidate has an MBA in marketing, paid if the candidate makes it to the interview process.
Both of Van’s referrals make it to the interview process, and one has an MBA in marketing.
Van receives $1,100 as his referral bonus ($600 + $500).
Annual Bonuses
An annual bonus, also known as a year-end bonus, is basically a “thank you” to employees for the work they’ve done throughout the year.
Companies pay these in different ways, like additional retirement contributions or paid time off, but they commonly issue them as monetary payments. Usually, the bonus is a percentage of the employee’s salary.
Example:
Emily’s company pays employees a 5% annual bonus.
Emily earns $100,000 a year, so her annual bonus is $5,000 ($100,000 x 0.05).
Retention Bonuses
Retention bonuses can be one-time or subsequent payments to encourage employees to remain at a company, especially in a critical role.
These bonuses can be paid as a flat-rate incentive—say, $1,000 when the employee reaches the six-month mark. Some companies pay larger sums in installments after outlining and signing an agreement with the employee.
Example:
Richard’s company pays a retention bonus worth 10% of Richard’s annual salary, provided that he remains with the company for at least one full year. The company pays Richard in installments that coincide with each of his biweekly paychecks (26 per year).
He earns $65,000 annually, making his one-year retention bonus $6,500 ($65,000 x 0.10).
With each paycheck, Richard gets $250 as his retention bonus installment ($6,500 / 26).
Holiday Bonuses
Holiday bonuses are paid toward the end of the year during the traditional holiday season, usually in November or December.
Most often, a holiday bonus is a lump-sum payment, which may vary by employee depending on factors like performance or years with the company.
Companies with several employees and a range of salary bands often base holiday bonuses on a percentage of annual pay.
Example:
Mary makes $80,000 a year. Her company pays a 2% holiday bonus to all employees in November.
Mary earns a $1,600 holiday bonus ($80,000 x 0.02).
How to Calculate Bonus Pay Tax
Bonus pay is a form of direct compensation. Generally, direct compensation to employees must have taxes withheld for federal, state, and local taxes, plus Social Security and Medicare, the Federal Insurance Contributions Act (FICA) taxes.
Bonuses are additional income for employees, so they get taxed. However, bonuses get taxed at a higher rate than regular payroll. For 2023, that rate is 22% for bonuses less than $1 million and 37% for bonuses over $1 million.
FICA tax is 6.2% for Social Security and 1.45% for Medicare, or 7.65% total.
Additionally, some states have their own rates, known as supplemental rates, for bonus taxes. For example, Ohio requires employers to tax bonuses at 3.5%, while Idaho’s supplemental rate is 5.8%. Local rates vary significantly.
Let’s say an employee in Idaho earns a $1,000 quarterly performance bonus. The company must tax it at 22% for federal taxes and 5.8% for Idaho’s supplemental tax.
$1,000 x 0.22 = $220 (federal taxes).
$1,000 x 0.058 = $58 (state taxes).
$1,000 x 0.0765 = $76.50 (FICA taxes).
$220 + $58 + $76.50 = $354.50 (total taxes removed by the employer).
$1,000 – $354.50 = $645.50 (total bonus received by the employee).
The IRS does offer another option, known as a de minimis benefit. This is reserved for small gifts or bonuses given to employees that are considered minimal in value and occasional, making them unnecessary to document as a bonus and, therefore, not necessary to tax.
De minimis benefits might include holiday gifts, flowers or fruit baskets, or an occasional employer-paid lunch. Generally, anything over $100 should not be considered as a de minimis benefit.
What is a Bonus Pay Gross-Up?
Bonus pay gross-up occurs when a company pays an employee for the money they lose to taxes. This can help reimburse employees who lose much of their earned bonuses to taxes.
To calculate a gross-up, an employer starts with the bonus’s net amount, or the full bonus minus taxes. Then, they calculate the gross pay needed to cover that tax amount.
Example:
The employee in the previous example will receive a $645.50 bonus after all taxes come out. Their employer wants to gross up their bonus to give them their full $1,000 earned bonus.
The total tax rate used on this bonus is 35.45% (22% federal, 5.8% state, and 7.65% FICA).
Subtract the tax rate from 1 (1 – 0.3545 = 0.6455).
Now, divide the employee’s bonus, $1,000, by that percentage ($1,000 / 0.6455 = $1,549.19). An employer wanting to gross up the employee’s pay should give a $1,549.19 bonus to cover its taxes.
How to Calculate Bonus Pay with Overtime
Overtime only matters for nonexempt employees, but it is something to consider if you’re paying bonuses. If you pay a nondiscretionary bonus, like commission, you’ll need to add the bonus to an employee’s pay before factoring in overtime.
For example, say an employee works 50 hours and earns $200 in commissions this week in addition to their weekly pay of $1,800. Add them together ($200 + $1,800 = $2,000).
Now, divide that total by the number of hours worked for the week. This employee worked 50 hours ($2,000 / 50 = $40).
Multiply this hourly rate by 1.5 (the overtime rate) to determine the employee’s overtime pay ($40 x 1.5 = $60).
The employee worked 40 hours at the regular rate of $40 and 10 hours at the overtime rate of $60.
40 x $40 = $1,600.
10 x $60 = $600.
The total amount the employee should earn this week with their bonus and overtime pay is $2,200 ($1,600 + $600).
It’s easy to make mistakes when running various calculations for different kinds of bonuses. Most companies use payroll software for this purpose.
The best payroll software automatically calculates bonus pay taxes and overtime correctly to ensure that your employee gets paid the correct amount, the company withholds the right amount for taxes, and the company remains compliant with bonus pay laws.
