How To Create a Compensation Plan

Updated June 24, 2022

Most businesses need to have a compensation plan detailing how to pay employees. A compensation plan is a package that encompasses employees' wages, salaries, benefits and terms of payment. Developing a compensation plan is essential in attracting and retaining talent within your organization. In this article, we discuss in detail what a compensation plan is, the different types of compensation plans and how to create one.

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What is a compensation plan?

A compensation plan is a formal document that states an organization's stance on employee pay and rewards. A compensation plan varies from one organization to another, depending on its compensation philosophy and prevailing market conditions. In the absence of a compensation plan, a company has no frame of reference on how to compensate employees. Relying on an ad hoc approach to compensation is likely to cause a high employee turnover. Ultimately, a compensation plan harmonizes industry practices and company policies that guide the creation and distribution of rewards to employees.

What are the types of compensation plans?

The most common types of compensation plans are salary, hourly and commission-based compensation plans:


Salary is paid at a fixed rate to an employee regardless of the number of hours worked. Besides a steady paycheck, a salaried employee enjoys additional benefits such as leave days, bonuses, health insurance coverage, retirement benefits and entitlement to minimum wage. Some companies also pay for overtime work hours spent by salaried employees.


Hourly compensation entails paying an employee a pre-agreed rate for every hour worked. They also receive overtime compensation for hours worked exceeding 40 hours per week. To track the time spent working, hourly employees are required to use timecards or an automated tracking system. Also referred to as non-exempt workers, hourly employees receive less than the minimum weekly wage per hour. They are also not entitled to benefits enjoyed by salaried workers.


Commission-based employees are compensated depending on the sales volume and the revenue they generate within a particular pay period, such as a month or a quarter. Some companies also provide a guaranteed base salary to commission workers regardless of performance. On top of base salary and commissions, some workers may also be paid bonuses as a reward for exceptional performance.

Related: Gross Pay vs. Net Pay: Definition and Examples

How to create a compensation plan

One of the most fundamental functions of management is to craft a compensation plan that is equitable, competitive and encourages employees to produce stellar performances. However, there is no one-size-fits-all plan applicable to all organizations and therefore knowing how to come up with one is essential for your business. Here are the key steps in creating a compensation plan:

1. Develop a compensation philosophy

The initial step in creating a compensation plan is establishing the reward philosophy and strategy you would like to adopt as an organization. A compensation philosophy is the basic principle underlying the compensation plan. A good compensation philosophy supports the business operations, enhances competitive advantage, and supports the organization's strategic plans. The philosophy guides all the decisions around how much pay, incentives and benefits to provide to your employees. A well-grounded philosophy addresses the following:

  • Which employees will be compensated

  • What type of compensation plan is suitable for your employees

  • Reasons as to why employees will be compensated

  • The legality of the compensation plan

  • Whether the compensation plan is fiscally sensitive, fair, equitable and defensible

The rejoinders to the checklist above help decide the basis of compensation rather than relying on an ad hoc approach. In contemporary times, most organizations are linking their compensation philosophy to performance, with high-performing employees claiming higher perks and vice versa. This approach is helping companies maximize return on investment used in employee compensation.

Read more: What Is Competitive Pay?

2. Gather relevant data from multiple sources

In crafting a compensation plan, it is vital to collect sufficient information to establish current market trends and position your organization appropriately. The nature and amount of information depend on the company size, the timeline of the project and whether you are updating an existing plan or crafting a new one. Some of the information to be gathered includes:

  • The current job descriptions of the various positions

  • Current compensation structure

  • A recent survey of pay structure

  • Employee sentiments on current pay structure

  • Impact of geography on employees compensation

To enhance the data's reliability, the information should ideally be collected from multiple, credible sources as this allows for triangulation and filling of data gaps. Unreliable data may affect the validity of findings and lead to wrong and costly decisions. Some of the credible sources of data you might consider for a salary survey include:

  • Evaluating wage data from government agencies such as the Bureau of Labor Statistics (BLS)

  • Purchasing a salary survey from a credible consulting company

  • Commissioning your own survey through a consulting company

  • Using data from trade and professional organizations

Related: What Is a Compensation Structure?

3. Benchmarking external to internal positions

Having obtained market data, the next step is to conduct data analysis to establish the benchmarking jobs that will be priced based on the market's externalities. It is advisable to benchmark 50-65 percent of jobs using market pricing to include at least 70 percent of all employees. The following tips are essential to remember in the benchmarking exercise:

  • Always compare job descriptions when deciding whether to match an external job to an internal position.

  • Select benchmark positions that are representative of the organization's main functions.

  • Take note of outliers and decide whether they should be included or excluded.

  • Make necessary adjustments regarding factors such as geography to reduce variability from one year to another.

  • Create a market composite for each benchmark position.

At the end of the benchmarking process, review current pay rates against market data. This enables you to create suitable pay structures that align with organizational compensation philosophy and in tandem with market realities.

4. Create a job description for each position

Develop a comprehensive description of the duties and responsibilities of every position. Take into account the job descriptions of similar positions in the market and the corresponding compensation. If several positions are doing more or less the same job, you may decide to merge the positions. Assign proper job titles to every position in line with prevailing market realities and internal organizational policy.

5. Develop the pay structure

Create pay structures by developing job grades, building a market pay line and establishing the pay ranges. A job grade is a group of different but equivalent jobs. Establishing job grades allows for similar jobs to be treated equally for compensation purposes. They also provide rules of promotion between one grade to another. A market pay line enables you to translate the market data into information for internal use.

Establishing pay ranges within job grades enables you to compensate employees depending on their experience, level of education and performance. Also, determine the benefits that you will provide in line with the company's budget. In developing a pay structure, ensure you comply with all federal and state employment laws.

Read more: What is a Scale of a Salary? A Guide for HR Professionals

6. Establish the cost of the pay structure

The pay structure has a direct impact on an organization's financial position. As a business leader, it is essential to establish the cost implication of the compensation plan and its sustainability. Besides the current cost of the pay structure, you should also consider the plan's future cost. A sustainable compensation plan should balance the current and future organizational needs without compromising its ability to attract and retain talent.

7. Document the compensation plan

Crafting a compensation plan is a long process and involves a lot of consultation, correspondence and paperwork. It is, therefore, vital to document the end product of the process be properly documented for future reference.

8. Implement and evaluate the plan

Implement the compensation plan developed. It is also appropriate that the details be shared with managers and employees to enhance transparency in the whole compensation policy. Knowledge of how the compensation system works enables consistency in decision-making. However, some organizations may choose to restrict access to the compensation plan due to the matter's sensitivity.

Over the compensation plan's implementation period, ensure you review the compensation plan to reflect the evolving market dynamics. For instance, you may need to review the structure to increase pay for skilled employees in high demand. You also need to update your compensation plan to be in sync with government policy and legislation.

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Frequently asked questions about compensation plans

Here are some answers to common questions about compensation plans:

How frequently should compensation plans be reviewed?

Compensation plans should be reviewed every two years. However, certain factors such as falling behind on benchmarking or competing for talent may force you into reviewing the compensation plan more frequently.

What do you do with an employee who feels their pay is unfair?

Employees are wont to question the fairness of their pay relative to their colleagues or counterparts in other organizations. To ensure few complaints about the compensation plan, ensure transparency of the compensation philosophy. Show employees how you pay them relative to the prevailing market rates.

What should you consider in evaluating compensation data?

There are several factors to consider when evaluating compensation data. These include:

  • Evaluate who participated in the survey and the geographical locations they represent.

  • Evaluate the number of employees participating in each breakout reported, because breakouts with statistically significant participation are more reliable than breakouts with limited reporting.

  • Beware of free surveys with questionable methodologies.

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