How Do Bonuses Work?

By Indeed Editorial Team

Updated April 12, 2021 | Published December 7, 2020

Updated April 12, 2021

Published December 7, 2020

Key takeaways:

  • Bonuses are a payment or incentivized reward added to an employee’s compensation package.

  • There are two ways to categorize most bonuses: discretionary (not guaranteed) or nondiscretionary (guaranteed as shown in your employment contract).

  • Companies often use bonuses as a way to increase productivity, improve employee retention, thank employees for their efforts and create a positive work environment.

Bonuses are a payment or incentivized reward added to an employee’s compensation package. In addition to wages or salaries, some companies provide regular bonuses to their employees. Each company’s bonus structure depends on the size and net worth of its business. In this article, we take a comprehensive look at how bonuses work by defining what they are and listing 12 of the most common types of bonuses.

What are bonuses?

Bonuses are a type of compensation paid to an eligible employee in addition to a previously set hourly wage, contract amount or annual salary. While many companies provide bonuses in the form of cash, a bonus can really take any form as long as it provides value to employees as well as the organization.

In most cases, bonuses are based on performance, meaning if you do an exceptional job reaching your goals on a specific project, you might receive a bonus from your employer. bonuses paid every calendar year as a percentage of the employee's salary or a fixed one-time payment amount.

Bonuses can be built into a company's budget in a discretionary fund, or they can be determined by the overall success of the company. Some bonus structures have multiple criteria including the company’s financial success, the performance of your team and your individual evaluation results.

Related: How To Calculate Employee Bonuses By Type

How do bonuses work?

Bonuses can come in a variety of forms, and employers can award them for myriad reasons. In most cases, a bonus will fall into one of these two main categories:

  • Discretionary: These arbitrary bonuses are awarded at the discretion of the employer, meaning they are not stipulated in your employment contract and are not guaranteed. The key to discretionary bonuses is that the employer has not set an expectation that a bonus will be paid, nor have the amount and timing of the bonus been given in advance. For example, spot bonuses and milestone bonuses are awarded at the discretion of your employer.

  • Nondiscretionary: These incentive-based bonuses are outlined in your employment contract. Usually, you receive the bonus if you meet certain criteria, like reaching a specific performance quota. As long as you meet the requirements detailed in your contract, the bonus is required as part of your compensation package. Signing bonuses and retention bonuses are examples of nondiscretionary bonuses.

Some types of bonuses are guaranteed while others are not. It's important to remember, too, that while the action of providing the bonus may be guaranteed, the amount of a bonus may not. Look closely at your employment contract to see if you should receive any guaranteed bonuses. You can also speak with a human resources representative to find out whether your company pays out a percentage of your salary or a flat rate when they calculate bonuses.

Read more: Discretionary vs. Nondiscretionary Bonus: Everything You Need To Know

Why do companies give bonuses?

The main objectives of bonuses are to make employees feel valued and increase productivity, and in doing so, they create a positive environment for collaboration and achievement of company goals. Bonuses are often used as incentives for current employees to encourage greater output, increase employee retention and show gratitude to employees for their effort and dedication.

During salary negotiations, a company might try to supplement their job offer to be competitive and attract top talent by extending a salary with a bonus. Similarly, when a candidate wants to negotiate salary further, but the hiring manager knows the company’s budget isn’t able to meet the candidate’s salary requirements, the hiring manager might offer a signing bonus to present a more appealing compensation package.

In some cases, you can negotiate a bonus when discussing your salary and benefits. Not every company provides a signing or retention bonus, but you can always ask if that's an option during the salary negotiation process. Usually, the only bonuses you can negotiate are nondiscretionary bonuses or those that are considered a part of your employment contract.

Related: What Are Fringe Benefits and How Do They Work?

Types of bonuses

Bonuses can really take any form, and the specifics can vary dramatically from company to company and job to job. A few of the most common types of bonus payments you might receive from your employer include:

Profit-sharing

One type of bonus some companies use is a profit-sharing plan. Employers often implement these plans because they want to give their employees a sense of ownership in the company. With profit-sharing, the company distributes a certain percentage of the company's quarterly or annual profits to employees, usually based on each employee's annual salary. Some companies provide the shares of profit as cash payouts, while others contribute the bonus payout to a 401(k) or another retirement plan on behalf of their employees.

Gainsharing

Gainsharing is a common bonus strategy used for the production and manufacturing sectors. Companies pay out bonuses to employees when they reach a certain metric, like increasing production by a specific percentage or lowering accident or defect rates by a certain amount.

Spot bonus

Companies give spot bonuses to employees for a variety of reasons. Usually, managers or supervisors are authorized to provide these relatively low costs—usually around $50 or $100—bonuses to employees who demonstrate a specific company value. For example, a manager might give a spot bonus to an employee for staying late to help a colleague finish a report.

Noncash bonus

A noncash bonus is any award or prize that isn't of monetary value. An example might be an extra day of paid time off or a coveted parking spot in the employee lot. Usually, noncash bonuses are tied to programs like employee of the month, and companies regularly award them to employees for meeting certain criteria.

Sign-on bonus

A sign-on bonus is a payout agreed upon when starting a new job. Companies often use this nondiscretionary bonus when trying to recruit highly qualified staff, to fill a role that has a high turnover rate or when a new employee is leaving a considerable amount of money behind at their past job—either through a salary cut or loss of guaranteed bonuses—to accept a new position.

Some companies pay signing bonuses in one lump sum, while others might spread the payments out over a year as a way to retain the employee in the role for a certain amount of time. Be sure to clarify the terms of your employment contract so that you understand any stipulations, especially for this type of bonus. For example, your contract might specify a conditional sign-on bonus that must be repaid if you leave the company before 12 months of employment.

Milestone bonus

Milestone bonuses—also known as task bonuses or mission bonuses—are directly tied to your work performance. Companies give milestone bonuses for reaching certain metrics or goals. The company decides the milestone in advance so a team or individual has a goal to work toward to earn the bonus payment.

Annual bonus

Companies usually give annual bonuses when the organization has a successful year. For some companies, annual bonuses are a guarantee, though the amount may differ from year to year depending on the company's profits. Other companies only distribute annual bonuses after a particularly successful year.

Retention bonus

Some companies provide retention bonuses to current employees to entice them to stay with the organization. Often, the company presents these in advance so employees know they're entitled to a certain amount of money if they stay with the company for a definite amount of time. Companies might also offer retention bonuses during a merger, acquisition or other major organizational change to keep staff numbers up through the transition.

Referral bonus

Another type of bonus is the referral bonus. This payment is given to employees who recruit talent to join the organization. Referral programs can vary from company to company, with some giving a flat payout rate regardless of the position, while others pay their employees more for finding candidates for hard-to-fill or executive-level roles.

Holiday bonus

Some companies provide a holiday bonus around the end of the year to all their employees. Usually, the value of this bonus is a percentage of each employee's annual pay. This practice is more common outside of the United States, but there are some companies in the U.S. that give holiday gifts not specifically tied to business profits or work performance but as a gesture of gratitude for employees’ efforts.

Stock options

Stock options allow employees to have ownership in the company. In this case, you'd be able to purchase shares at a fixed rate and gain money (in stock value) as the company succeeds. Instead of giving away shares directly, employers give their employees the option to acquire a certain number of shares at a discounted rate. While stock options don’t have a straightforward value like a signing bonus, they can still be a valuable asset to your finances.

Related: How DO RSUs Work? (With Example)

Commission

Many jobs work on commission with employees receiving a portion of their wages based on sales performance as a part of their standard salary. Employees who work on commission usually receive commission pay with every paycheck, and the amount they earn directly correlates to the profits they brought to their employer.

Usually, employees in a commissioned role understand that the amount of money they make annually will depend on how successful they are at their job. Since their income is not guaranteed like an hourly wage or an annual salary, commission is often considered a type of bonus. Certain positions and industries are more likely to work under a commission structure, including real estate, account management, finance and recruiting.

Bonuses and commission are both additional pay that employers add to your base salary, but they do have some key differences. Often, a commission is built into an employee's pay structure with the understanding that their performance determines how much they get paid.

Related: How To Calculate Employee Bonuses By Type

Is it better to get a raise or a bonus?

Generally speaking, as an employee, it is often better to get a raise than a bonus. Here are some reasons to compare getting a raise vs. getting a bonus:

  • A raise increases your long-term earning potential. A raise increases your base pay. Ideally, your salary expectations should increase over time during your career.

  • A bonus is not part of your salary. In most cases, bonuses are one-time payouts.

  • You are guaranteed to earn more money with a raise. Your hourly or yearly pay rate is locked in for the duration of time you spend with the company when you receive a raise.

  • Most bonuses are not guaranteed. An employer might only offer a bonus when sales have been strong for the year. So, if sales were down during a given year, you probably would not receive a bonus.

  • Bonuses are taxed as supplemental wage income. Cash bonuses are considered supplemental income and are taxed at a higher rate than regular pay. Additionally, bonuses are subject to social security, Medicare and state taxes. By the time all of these taxes are taken out of your bonus check, you will have a large chunk missing from the original amount.

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