What is a cost-of-living pay adjustment?

A cost-of-living pay adjustment refers to an increase in an employee’s rate of pay based on estimates of how much money is required to maintain a given standard of living. Cost-of-living pay adjustments can be applied to wages or salaries, benefits and other compensation packages and are intended to offset inflation.

Cost-of-living adjustments usually take into account where the employee is based, rather than simple nationwide interest rate calculations. So if your offices are in San Francisco and the cost of living has increased by 10%, you may choose to offer a salary increase in line with the increasing expenses faced by those living in the area.

In addition to adjusting individual pay rates based on the cost of living, it may also be useful to adjust pay bands, if your organization uses them. This will help ensure new employees start at a fair salary and also help existing employees by increasing the upper limits of the band, so longstanding employees don’t find themselves having their pay artifically restricted by having reached the top of a pay band.

Related: How to Communicate a Pay Raise

Best practices for cost-of-living pay adjustments

Here are some tips and best practices for awarding cost-of-living pay adjustments:

• Keep an employee’s salary commensurate with their living expenses. As an employer, it’s important to offer reasonable salaries and wages to your employees. A reasonable yet competitive salary based on the cost of living in your company’s city is appealing to both applicants and current employees. It also promotes a healthy work-life balance when your employees are able to afford basic life necessities.
• Give regular raises. When it’s time to review an employees salary, cost of living adjustments should be considered separately from performance-related pay increases.  Regular raises will help you retain employees who have valuable experience and prevent them from seeking a new job elsewhere to avoid the phenomenon of salary compression.
• Customize the cost-of-living pay adjustment for each employee given their location. If you have employees working across the United States, adjust their pay increases accordingly. The cost of living salary adjustment for someone in New York may be higher than for an employee living in Nashville, for example. Research salaries and expenses in each area to confirm each salary is adjusted for cost of living variations in that area.
• Research market rates. When calculating cost of living increases, look at the market rates for similar positions in the area. Depending on demand or skills shortages, salaries can change dramatically. Hiring in a competitive market can be challenging, and offering competitive pay is a useful way to retain employees.
• Set boundaries. If your company is entirely remote and employees are able to move wherever, it’s important to let them know upfront if you’re not able to offer them a cost-of-living pay adjustment if they choose to relocate. In addition, if you have more than one office and an employee is relocating, be transparent about how you’ll handle pay and relocation budgets for them.
• Offer an increase when earned. Try to award pay increases at a time when the employee has earned it, or as part of a performance review, rather than simply awarding automatic pay increases across the board. This helps avoid setting a precedent where employees can expect automatic pay increases even if they aren’t performing well.

Unions and cost-of-living adjustments

Many unions include a clause about cost-of-living adjustments in their contracts to protect their members from the creeping effects of inflation.

This clause will usually lay out how inflation is measured and also specify how often the worker’s pay should be adjusted. There are several different CPI measures, but the two most commonly used by unions are the CPI-U and the CPI-W.

The CPI-U is the All Urban Consumers index, and is designed to reflect the purchasing patterns of 88% of the population. This makes it the most commonly used CPI for COLA calculations.

The CPI-W is a subset of the CPI-U and is often used to calculate COLA for blue-collar professions. There can be significant differences in the pay increases awarded by these measures, so it’s vital to use the right measure when working out pay adjustments.

Private vs. government pay adjustments

Cost-of-living adjustments are common in government organizations, but they’re also used in the private sector. Governments usually use cost-of-living adjustments as a way of calculating benefits or disability payments, and they will often revise pay bands for public service positions based on the cost of living, too.

In the private sector, it’s more common for organizations to alter pay, as well as employee benefits and perks, based on experience or performance, rather than simply changes in the cost of living. If you’re responsible for pay policies at a private, for-profit organization, you may find it beneficial to tie pay rises to performance targets, so you have some control over how productivity influences pay. Set clear HR policies so your employees know exactly where they stand and what they can expect from a performance review.

Neither government agencies nor employers are required to offer cost-of-living pay adjustments. However, it’s a good idea to consider them if you’re asking employees to relocate to a higher cost-of-living area or if the cost of living has increased significantly since the employee’s last pay review. Employees that are paid fairly and who aren’t facing undue stress over their bills are more productive and are more likely to remain loyal to your organization.

Cost-of-living adjustments FAQs

Here are some common FAQs when it comes to cost-of-living pay adjustments:

Are COLA adjustments mandatory?

There is no legal requirement for employers to provide cost-of-living adjustments. However, employees who are part of a union may have COLA pay as a part of their contract. For most employers, however, cost-of-living adjustments are entirely discretionary.

How do you determine the cost-of-living increase?

If you decide to give a cost of living increase, you have the option of using national data such as the Consumer Price Index, or regional data. The cost of living changes based on inflation and regional trends. For example, supply chain issues or even extreme weather or energy supply concerns could drive up the cost of living in a secific area.

What’s an example of a cost-of-living pay adjustment?

If you’re not sure how to calculate CoLA, just treat it like a standard math problem. Let’s imagine your company has offices in Boston. In the past year, the cost of living in this city rose by 5%. Because of this, you decide to give your employees a 5% increase in their wages. If one of your employees has a salary of $50,000, you would perform the following calculation:

$50,000 x 0.05 = $2,500

$50,000 + $2,500 = $52,500

Therefore, you would give them an increase of $2,500, which would make their new salary $52,500.