Pay compression: What it is & what to do about it

When newer employees earn nearly the same or more than experienced ones doing similar work, organizations face a challenge known as pay compression. This compensation issue has serious consequences for employee morale, retention, and overall business performance. When left unaddressed, pay compression can lead to perceptions of unfairness, disengagement, and even legal risks.

This piece explores the causes and impacts of pay compression, along with practical strategies to identify and address it. By the end, you'll learn how to build fair, competitive compensation structures that keep employees motivated and engaged.

What is pay compression?

Pay compression, also known as salary compression or wage compression, occurs when there is little difference in pay between employees regardless of their skills, experience, or seniority. It commonly happens when the pay of lower-level employees increases at a faster rate than higher-level ones, leading to a "squeezing" or "compression" of salary ranges.

A frequent scenario is when companies keep raising starting salaries for new hires in response to labor market competition without proportionally adjusting the pay of existing employees. Over time, the gap between what new and tenured employees make for the same job shrinks, potentially even inverting.

For example, imagine you hired an IT analyst last year at a salary of $75,000. This year, due to a tech talent shortage, you had to offer a new analyst with similar skills $85,000. If you don't adjust that first employee's pay, they may now be paid less than a newer, less-experienced colleague.

Human resources teams often encounter this issue when reviewing compensation data and finding that tenured employees' salary ranges haven't kept pace with rising market rates in the current job market. This affects both salaried positions and hourly workers across all levels.

While pay compression isn't technically illegal under federal law, it can open the door for discrimination claims if it leads to unfair pay differences between members of protected classes. It also tends to have a demoralizing effect that can hamper engagement and worsen turnover if not properly managed.

6 causes of pay compression

There are several common drivers behind pay compression, both external and internal to organizations:

1. Market forces and talent competition 

When the demand for certain skills exceeds the supply of workers, employers often have to offer higher salaries at market rate to attract new hires. Technology fields like software engineering are especially prone to this. Without corresponding raises for current employees, salaries start converging.

2. Union contract or minimum wage increases

When governments raise the minimum wage, or labor agreements lift pay scales, it can bump up compensation at the bottom of an organization's pay ranges. Unless all wages are proportionally raised, these increases compress the overall range and erode the pay differences between experience levels.

3. Inadequate raise pools during tough times

During economic downturns or tight budget periods, organizations may skimp on salary increase budgets or freeze raises altogether. This can compress wages as the market moves on and new hire rates rise. For example, a company might freeze raises during a recession, but then have to hire a new developer at $80,000 while a three-year employee with similar skills remains at $75,000.

4. Poorly defined pay bands 

If an organization lacks clearly defined pay ranges for roles, with set minimums and maximums based on market data and internal equity targets, it's easier for pay to become asymmetrical over time with new hires coming in at or above incumbents. This often happens when hiring managers have too much discretion in setting starting salaries without considering team-wide compensation balance.

5. Reliance on tenure-based pay vs skills-based pay

Organizations that reward employees primarily based on tenure, rather than evolving market rates, skills, and responsibilities, may find veteran employee wages stagnating relative to new hires. For instance, a 10-year customer service representative might earn just 5% more than someone hired last month, despite their deep product knowledge and experience.

6. Infrequent market analysis and benchmarking

Pay compression often sneaks in when companies don't regularly analyze both market pay rates and internal compensation metrics. Without consistent benchmarking and proactive adjustments, it's easy for misalignments to worsen unnoticed. This is especially problematic when supervisors lack visibility into market rates and salary ranges for their direct reports, making it difficult to advocate for appropriate pay adjustments during review cycles.

The impact of pay compression on businesses

Pay compression does more than breed frustration among employees who feel undervalued. Understanding the consequences of underpaying employees is crucial, as it can severely impact overall business performance:

Low morale and productivity 

When employees perceive their pay as unfair compared to colleagues, it erodes trust and motivation. They may feel less incentivized to go above and beyond or take on additional responsibilities commensurate with their tenure. Disengagement and resentment can fester, undermining both individual and team productivity.

Increased turnover and recruiting difficulties

If employees feel they're not being paid fairly, they're more likely to look for other opportunities. Turnover can especially spike after annual raises or bonus time, if employees compare notes and realize they're earning less than peers. High turnover then makes recruiting harder, especially if word gets out that you don't pay market rates.

Poor employer brand and reputation

In today's era of employer review sites like Glassdoor, it's easy for word to spread if a company underpays employees. Overall brand reputation and candidate perceptions can take a hit, making it harder to attract talent and potentially even customers. Negative publicity around unfair pay practices can also draw regulatory scrutiny or legal challenges.

Wasted investments in training and development

When salary compression leads to turnover, companies lose out on their investments in onboarding, training, and developing employees for success. Unexpected departures can leave skills gaps that are both costly and time-consuming to refill, stalling key projects and strategic initiatives.

How to identify pay compression

Spotting pay compression requires a combination of quantitative analysis and qualitative feedback. Key indicators include:

1. Calculating compa-ratios 

A compa-ratio compares an employee's actual salary to the midpoint of their salary range. If compa-ratios are consistently lower for highly tenured employees than new hires, it suggests veteran pay has fallen behind the market. For example, if experienced employees have ratios of 0.85 while new hires are at 0.95, there's likely compression.

2. Analyzing pay increase histories 

Take a look at salary increase percentages for employees over time. If newer employees are getting substantially higher annual raises than experienced ones, chances are the ranges are compressing. This analysis should include both merit increases and market adjustments to get the full picture.

3. Comparing salaries for similar jobs

Pull compensation data for employees in the same or very similar roles and analyze how the figures vary by factors like tenure, skills, performance, and location. For instance, if a five-year software developer makes $95,000 while recent hires earn $92,000, that's a clear compression warning sign.

4. Benchmarking to market data

Look at reputable salary surveys for your industry, location, and company size. If starting salaries are consistently at or above what you're paying incumbents, your ranges are likely misaligned with the market. Regular benchmarking helps ensure your compensation structure stays competitive and fair.

5. Monitoring employee complaints and reviews 

If you start hearing grumblings about unfair pay, or see an uptick in negative reviews about compensation, it's worth investigating if certain employees or roles are falling prey to compression. Regular pulse surveys and exit interviews can also help to provide valuable insights into potential compensation issues.

How to address and prevent pay compression: 5 strategies

Resolving pay compression takes effort, but it's essential for maintaining an engaged, productive workforce. Some effective strategies include:

1. Conduct a thorough pay equity analysis 

Start by auditing current compensation across the organization to identify where compression and pay inequities exist. Analyze salaries by job title, department, location, as well as demographics like gender and race to surface any problematic patterns. Document your findings to inform remediation plans.

2. Develop market-informed salary bands

Establish clear pay ranges for every role using a combination of external market data, internal equity targets, and your compensation philosophy. Set defined minimums, midpoints, and maximums to guide starting salaries and raise decisions. Be sure to account for factors like job level, skills, geography, and experience.

3. Correct individual salaries and pay policies

Based on your salary bands, adjust incumbent salaries as needed to restore parity with the market and ensure fair pay for performance. Document your methodology for making changes so you can explain the rationale. At the same time, update your compensation policies and train managers on how to make consistent, equitable pay decisions.

4. Communicate proactively to employees

Let employees know you've conducted a pay analysis and share an overview of your findings and go-forward plans. Reinforce your commitment to fair, competitive pay. Consider holding info sessions or office hours to answer individual questions—transparency goes a long way in rebuilding trust if employees were feeling undervalued.

5. Monitor market rates and internal equity regularly

Wage compression isn't a one-and-done fix—preventing it requires ongoing discipline and analysis. Benchmark your ranges to market data at least annually and make adjustments as needed. Analyze compa-ratios and flag any internal equity issues ahead of each pay review cycle. Some companies even do quarterly audits to ensure they're not falling behind.

Boost fair compensation with Rippling

Conducting pay audits and defining competitive salary bands can be time-consuming but powerful software like Rippling can help you prevent pay compression more efficiently.

Rippling's unified compensation management platform helps make fair pay practices simpler by allowing you to:

• Create and manage compensation bands that automatically map to employees based on their roles, while controlling sensitive pay data through role-based permissions
• Track compa-ratios across your organization and quickly identify potential compression issues or outliers
• Set up automated workflows that flag compression risks—like when an employee's compa-ratio drops after a location change
• Enforce pay policies by automatically routing off-band adjustments through approval workflows
• Analyze pay equity across departments, locations, and other employee attributes to spot disparities early
• Integrate compensation planning with headcount management to keep salary costs aligned with budgets
• Consolidate all compensation data in one system, eliminating scattered spreadsheets

With Rippling, you can feel confident your pay practices are fair, competitive, and compliant—without spending hours wrangling spreadsheets. The platform's powerful analytics tools give you instant insights on pay equity so you can spot and resolve compression before it spirals into a bigger issue.

FAQs on pay compression

What role does transparency play in addressing pay compression? 

Transparency is key on two fronts: clear communication to employees on your pay practices and commitment to fair compensation, and a willingness to have open conversations with employees about their individual pay. While you may not share everyone's exact salaries, being clear about your compensation strategy, philosophy, and criteria for pay decisions helps dispel perceptions of unfairness or favoritism that can arise with pay compression.

What tools can HR teams use to manage pay compression?

A combination of market salary surveys, internal pay audits, and compensation management software will be an HR team's best bet for preventing and resolving pay compression. Utilizing a salary compression calculator provides additional insight into potential pay inequities. Dedicated compensation management software like Rippling can bring all your pay data together for modeling and analysis in one place.

Does pay compression only affect large organizations?

Pay compression can happen in organizations of any size if there isn't sufficient rigor and consistency to compensation management. While larger enterprises may be more prone to it by virtue of wider pay spreads and manager discretion, small businesses can experience compression too, especially in competitive talent markets forcing up new hire salaries. Proactive monitoring and adjustment is key in all cases.

What are the risks of ignoring pay compression?

The risks of unaddressed pay or salary compression are significant—top talent losses, waning productivity, reputational damage, even potential legal claims under equal pay laws if compression correlates to gender or racial disparities. While resolving compression can require tough budget decisions, it pales in comparison to the cost of regrettable turnover and disengagement. Protecting fair, competitive pay is an investment in your most valuable asset—your people.

This blog is based on information available to Rippling as of December 11, 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.