What Is Cost-of-Living Adjustment (COLA) and How Is It Used?

By Jennifer Herrity

Updated March 25, 2021 | Published January 13, 2021

Updated March 25, 2021

Published January 13, 2021

Jennifer Herrity is a seasoned career services professional with 12+ years of experience in career coaching, recruiting and leadership roles with the purpose of helping others to find their best-fit jobs. She helps people navigate the job search process through one-on-one career coaching, webinars, workshops, articles and career advice videos on Indeed's YouTube channel.

A cost-of-living adjustment is a change in income or benefits that corresponds with the current cost of living. Companies, unions and governments can make cost-of-living adjustments for employees to counteract the creep of inflation. Adjustments can manifest as an increase in Social Security benefits, an alteration in salary or as a change in the price of consumer goods. In this article, we explain why and how a cost-of-living adjustment is helpful and look at the different ways it is calculated.

Why is a cost-of-living adjustment important?

A cost-of-living adjustment is important because it allows employees, retirees and people living on fixed incomes to afford housing, goods, services and taxes as prices increase over time. Companies and governments might make cost-of-living adjustments for:

  • Union member contracts, such as for U.S. Postal Service employees

  • Retirement benefits, such as Social Security and Supplemental Security Income

  • Private-sector employee salary increases

  • Government employee salaries

  • Employee relocation to a city or state with a higher cost of living

Some cost-of-living adjustments are permanent, while others are temporary, such as those for military members on short-term assignments in expensive regions.

One of the best-known cost-of-living adjustments is one that the U.S. Social Security Administration makes every year to ensure people receiving Social Security benefits can maintain their standard of living after inflation. It announces its annual cost-of-living adjustment every third quarter of the year. This adjustment usually matches the annual change in the Consumer Price Index for Urban Wage Earners and Clerical Workers.

Governments, which typically pay lower salaries than companies for similar jobs, often include cost-of-living adjustments in their benefits packages to attract skilled employees. Companies might offer cost-of-living adjustments as well to stay competitive and attract and keep good employees. Cost-of-living adjustments might also make potential employees more likely to accept a job offer that requires relocation. An employee relocating from Houston to New York City, for instance, must pay significantly more for housing, goods and services in New York than in Texas.

Related: Cost of Living: Definition and How To Calculate it

How to calculate cost-of-living adjustments

Organizations can calculate cost-of-living adjustments using a variety of methods. These include:

1. Cost-of-living index

Companies might use the cost-of-living index to determine how much to pay an employee who is relocating. The cost-of-living index is a comparison of living costs by city or region. To calculate your cost of living:

  1. Set the cost-of-living index in your current city at 100.

  2. Determine the average cost of similar items (healthcare, groceries, transportation and other goods and services) in each city.

  3. Calculate the percent difference between the price of each item.

  4. Average the percent difference for all items.

  5. If the cost of living is 20% higher in the new city, its cost-of-living index is 120.

You can find reliable cost-of-living figures on the Council for Community and Economic Research website.

2. Consumer Price Index

To determine how much to adjust salaries due to inflation, companies might use the Consumer Price Index, or CPI. This index is one of the most commonly used tools to measure inflation. To calculate changes in CPI, the Bureau of Labor Statistics:

  1. Lists more than 80,000 items that represent the average household's purchases, including groceries, housing, clothing, transportation, healthcare, recreation and education.

  2. Conducts surveys around the country to determine the average prices of these items.

  3. Calculates each category or item's CPI by dividing the current year's average price by the base year's average price and multiplying the total by 100.

  4. Weighs categories of items by importance to determine an average CPI figure (for example, the grocery category has half the value of housing).

The Bureau of Labor Statistics calculates CPI monthly and annually for the entire country as well as the Northeast, Midwest, South and West regions.

Related: 5 Tips To Negotiate for a Cost of Living Adjustment

3. Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W)

The Social Security Administration uses this form of CPI to calculate inflation and make cost-of-living adjustments to Social Security and Supplemental Security Income. To calculate CPI-W, the Bureau of Labor Statistics uses the same steps as it does to calculate CPI but with items that affect specific demographics. These demographics include:

  • Households where at least half of the total income is from clerical or wage-paying jobs

  • Households where at least one person has been employed for at least 70% of the year

For example, if an individual received $12,000 in Social Security benefits and the year's CPI-W is 3%, their Social Security payment for the next year would rise by 3% to $12,360. The Bureau of Labor Statistics releases the current CPI-W in the third quarter of each year.

4. Consumer Price Index for All Urban Consumers (CPI-U)

The CPI-U measures the average change in the prices consumers pay for goods and services over time. It is a broader measurement of price changes than the CPI-W because it includes more demographics, including:

  • Clerical workers

  • Retirees

  • Self-employed professionals

  • Technical workers

  • Temporary workers

  • Wage-earners

The Bureau of Labor Statistics uses the CPI-U to measure inflation and deflation, but the CPI remains the most accurate calculation of cost of living.

Related: A Guide To the Inflation Rate

Cost-of-living adjustment tips

If you receive a cost-of-living adjustment or want to determine what your adjustment should be, consider these tips:

  • Inflation is common and occurs continually. Therefore, your salary and Social Security benefits should receive cost-of-living adjustments over time.

  • Your salary typically goes further in a region with a low cost of living than one with a high cost of living.

  • Cost-of-living adjustment calculations vary between employers—there is not one official metric that all companies follow. However, many employers base their adjustments on the CPI.

  • Companies typically give salary increases based on employee performance rather than cost of living. However, you can use cost-of-living calculations to negotiate an appropriate salary when accepting a new job or relocating to a new city.

  • Use a cost-of-living calculator, which you can find by searching online, to estimate what your adjustment should be. Do this annually to assess inflation or when moving to another region.

  • Calculating your cost of living can help you budget and prepare for the cost of common goods and services when you relocate or start a new job.

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