What is a compensation plan? Types, benefits, and best practices

A strategic compensation plan helps companies attract and retain top talent. 

While pay and benefits remain critical factors when considering a job offer, employees' expectations are increasingly shifting toward non-monetary incentives (which can have monetary value), such as career development, growth, rewards, and recognition—not to mention the importance of achieving optimal work-life balance.

Compensation planning is not a one-time job; it is an ongoing process that requires regular evaluations and adjustments based on market trends and changing employee preferences. 

Keep reading to learn about compensation plans, how to create them, and the importance of well-thought-out compensation programs for business growth. 

What is a compensation plan?

A compensation plan is a strategy companies design to attract, retain, and reward employees. It outlines the amount employees are paid and includes factors that influence salary and bonus ranges—like job qualifications, experience, and type of employment. Such pay rate structures are also known as salary bands.

Compensation plans also explain when and under what conditions employees are eligible for bonuses and typically include information regarding employee benefits.

There are various interpretations of compensation plans. Some define them strictly as covering direct payments like salaries and bonuses. When benefits and incentives, like stock options, are added, then they're referred to as total compensation plans or total rewards plans. 

Direct vs. indirect compensation 

Salary and bonuses are direct compensation, as they are cash payments made straight to an employee. Indirect compensation includes non cash benefits like paid vacation days and health insurance. 

Employees' direct compensation is often tied to their performance (e.g., top salespeople are better positioned to receive raises and bonuses), while indirect compensation, such as healthcare benefits, is not performance-based. 

Employers also often consider tenure and experience levels when forming direct and indirect compensation rates. For instance, an inexperienced candidate will likely receive entry-level pay, while a senior-level candidate will receive a salary commensurate with more experience.

Similarly, with indirect compensation, employees who have been with the company for a long time typically have more paid vacation days than new hires. 

Direct compensation includes:

• Salary
• Hourly wage
• Commission
• Bonuses
• Profit sharing plans
• Stock options

Indirect compensation can include:

• Life insurance
• Retirement plans
• Health insurance
• Disability insurance
• Paid time off
• Sick leave
• Flexible work hours
• Development programs
• Recreational programs and gym memberships

3 types of compensation plans

Learn about common compensation plan examples below.

Salary-based compensation

Salary-based compensation refers to a fixed amount an employee receives monthly or biweekly, regardless of the number of hours they work. Salary-based compensation plans typically outline employee benefits beyond their base pay, including leave entitlements, pension contributions, and health insurance coverage. 

These programs may also provide other types of direct compensation, such as bonuses or equity. Depending on the compensation plan terms and applicable labor laws, salaried employees may sometimes be eligible for overtime pay. 

Hourly wage compensation

An hourly wage is a fixed amount employees receive for each hour of work. Although their earnings vary depending on the hours worked, they must be paid at least the legal minimum wage per hour. Hourly workers are often eligible for overtime pay if they work beyond a standard eight-hour workday. 

Unlike salaried employees, hourly employees typically do not qualify for certain employee benefits, such as paid time off and health insurance. However, that could depend on the average hours worked per week.

Commission-based compensation

Commission-based compensation links an employee's performance to their financial reward. It is often used in sales roles. Employees are compensated based on the target reached within a particular pay period, typically monthly or quarterly. 

Some companies provide a base salary in addition to commission, ensuring employees receive regular pay regardless of performance. Additionally, commission-based compensation plans may outline the terms and conditions for receiving bonuses and other incentives.

5 benefits of compensation plans 

If you’re wondering whether your business needs a compensation plan, consider these key advantages.

Attract and retain top talent 

A well-structured compensation plan helps attract and retain high-performing employees. Competitive salaries, fair pay, attractive bonuses, and comprehensive benefits packages make your company appealing to top candidates and encourage existing employees to stay long-term, reducing turnover rates. 

Enhance employee motivation

While salary is not the only motivation, it plays a significant role in job satisfaction. Employees are motivated to perform at their best when they know they are valued and fairly paid.

Monitor legal compliance

Navigating labor laws, especially when managing a remote workforce and international teams, can get complicated. However, compensation planning helps meet minimum wage requirements, benefits, and leave entitlements, which helps businesses comply with applicable employment laws. 

Promote diversity, equity, and inclusion

Compensation plans outline the structure and criteria for pay and benefits. When employee compensation is based on factors such as type of employment, qualifications, and experience, it creates a culture of transparency and fairness, eliminating the risks of unconscious bias. 

Manage your budget responsibly

Compensation planning helps you keep track of your spending. Not having a plan could result in losing valuable employees because you are not paying them adequately. You also run the risk of providing incentives untethered from experience or performance, putting your financial stability in danger. 

How to create and implement a compensation plan: 8 Steps 

Now let's discuss how to create a compensation plan. 

Step 1. Develop a compensation philosophy

Compensation philosophy is the foundation of your compensation plan. It is a framework that defines the structure and principles of your compensation strategy. 

When establishing a compensation philosophy, consider the culture and environment you want to create and what will distinguish your business from others.

Basically, your compensation philosophy should guide decisions on how much to pay your employees and determine whether your pay structures match or exceed market standards to give you a competitive advantage. Of course, you also need to align your compensation philosophy with your company's size and budget, so you can be realistic about what you can offer current and prospective employees. 

Step 2. Outline compensation goals

Once you define your compensation philosophy, the next step is to set objectives—what you want to achieve through your compensation plan. 

Companies typically create compensation packages to 

• Attract top talent
• Improve employee retention
• Enhance employee engagement
• Increase job satisfaction
• Set strategic headcount plans

If you want to find and keep top talent, it helps to conduct market research through salary benchmarking, which entails studying market standards on salary ranges, bonuses, and benefits. 

The Bureau of Labor Statistics (BLS) could be a good resource. If your budget allows, you can purchase employee surveys from reputable consulting companies or private market databases. 

Also, do a competitive analysis to see what your competitors are doing. Establish their strengths and weaknesses, and see what you can offer to stand out. 

In parallel, consider conducting region-specific cost-of-living research to gain insight into what potential hires consider fair and adequate pay in their location. Such information could be valuable for creating competitive compensation and increasing candidates' interest in you as an employer.

This approach can be applied to every goal because the more information you have, the more actionable compensation management will be.

Step 3. Appoint a compensation manager

This can be someone from the human resources (HR) department, or you can consider hiring a full-time or part-time compensation manager. This person will be in charge of putting together and implementing the compensation plan by: 

• Collecting and analyzing compensation data
• Assessing pay equity across the workforce
• Monitoring compliance with compensation laws and regulations

Step 4. Define seniority grades for every job classification

Defining seniority grades is essential as it helps employees understand how different levels of experience—such as junior, intermediate, senior, or lead—influence their pay, career path, and status within a company. Employers tend to be more engaged when they see how their performance and commitment impact their professional and financial growth. 

Step 5. Create a job description for every position

When creating job descriptions, be as detailed as possible. Clearly outline all duties and responsibilities associated with the role and ensure that the compensation rate reflects the market standard for similar positions. Consider how similar roles are titled in the industry to ensure consistency and competitiveness. 

Step 6. Build a career progression framework

A career progression framework typically outlines the skills and levels of experience needed to move from one seniority grade to another. 

It could also contain information about monetary and non-monetary resources companies provide to support their employees’ career advancement. This can include mentorship programs or financial support for certifications and further education. 

A strategically created career progression framework fosters employee growth while enhancing employee engagement and retention. 

Step 7. Develop the pay structure

To develop a pay structure, consider market data, seniority levels, and salary ranges. This type of benchmarking helps you create a pay structure that will put you in line with market trends. 

Job grades, such as entry-level, mid-level, and senior executive—help monitor pay equity for roles of similar complexity. Pay ranges (or compensation bands) explain the minimum and maximum amount an employer will pay for specific roles. An employee's position within a pay range depends on their qualifications, performance, and experience. 

Step 8. Get other leaders' buy-in

Once the plan is completed, it is critical to communicate with other leaders and gather their opinions regarding the proposed strategy. Implementation starts when everyone agrees that the content and structure of the compensation packages align with the company's overall business strategy. 

Legal compliance and equity in compensation planning

Compensation plans enhance organizational transparency by giving employees an overview of pay structures. This allows them to assess whether the plan treats everyone equally regardless of factors such as gender, race, or age.

A compensation strategy will only be successful if employees perceive it as fair. Gathering feedback can be invaluable for business owners and HR professionals, helping them make necessary adjustments and improve the program's effectiveness and applicability. 

You should also ensure the proposed compensation package complies with state and federal laws—like adhering to relevant overtime requirements.

3 compensation program best practices for easy management 

Run market research 

Market research can help your compensation package remain competitive. Analyze industry benchmarks to understand what other organizations offer to their employees. Staying informed enables you to align with market standards or even exceed them, which helps you attract and keep top talent. 

Rely on HR software

HR software can streamline compensation plan management and improve accuracy. These systems can automate calculations, track employee performance, and generate reports, making it easier to manage compensation and benefits. You can also use headcount planning software to align HR, finance, recruiting, and department heads on approved pay bands. 

Review the compensation plan regularly 

Regularly reviewing your compensation plan template is critical for maintaining the program's relevance and efficiency. Reviews can be done every six months or yearly. The aim is to evaluate how the program works and whether it aligns with employee expectations and organizational goals. Regular reviews allow you to detect areas for improvement and quickly adapt to market changes and your company's needs. 

Easy headcount and compensation planning with Rippling

Rippling is an all-in-one platform that unifies global HR, finance, and IT, enabling you to take full control of compensation management. 

Rippling's headcount planning and compensation bands feature helps you create and stick to an approved budget, enabling you to develop and apply market-competitive and location-appropriate pay rates. And thanks to integrations with Carta, Rippling gives users access to the world’s largest private-market database of salary and equity benchmarks across more than 40,000 startups, helping companies set competitive and equitable pay bands no matter the job. 

Compensation plan FAQs 

What does a good compensation plan include?

A good compensation plan includes direct and indirect forms of compensation, such as base pay, bonuses, and benefits. It should also outline the criteria for performance evaluation and career progression and reflect the company's overall compensation philosophy. 

How do I ensure my compensation plan is competitive?

Regular market research helps you understand industry trends and assess whether your compensation package needs adjustment. Keeping your compensation competitive helps you to attract and retain top talent

How often should compensation plans be reviewed?

Compensation plans should be reviewed at least once a year. Regularly evaluating their relevance and effectiveness helps make adjustments that align with business needs, adjust to cost of living changes, and meet employee expectations.

This blog is based on information available to Rippling as of October 28, 2024.

Disclaimer: Rippling and its affiliates do not provide tax, accounting, or legal advice. This material has been prepared for informational purposes only, and is not intended to provide or be relied on for tax, accounting, or legal advice. You should consult your own tax, accounting, and legal advisors before engaging in any related activities or transactions.