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Compensation Plans: Definition, Types & How To Create In 2023

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Offering a fair compensation plan for roles within your business ensures you acquire and retain qualified employees. You want to start with a base level for each position, ensuring the employees earn what they deserve.

Going above and beyond that base salary will make your company one that attracts the top professionals. These people expect to make what they’re worth, with some perks to draw them to your company over any others. When potential applicants are doing salary research, you want your business to offer the best options.

Learn about compensation plans and what you should offer your employees.

What Is a Compensation Plan?

A compensation plan, also known as a compensation package, refers to the payment and benefits an employee receives for working at a company. Since employees give their time and service to the business, they receive compensation.

Benefits that count as compensation include:

  • Insurance coverage
  • Paid leave
  • Retirement matching
  • Salary
  • Stock options

It’s easy to confuse salary and compensation. Your salary is the money you earn for one year of work. The compensation includes your salary and all benefits included for your role, such as those listed above.

The Importance of a Compensation Plan

A defined compensation plan helps employees understand what the company gives in return for their effort. A compensation plan can help you stand out from similar businesses in that industry. Qualified employees will want to work for you if you offer more than the competition.

Providing an overall compensation structure also shows employees how they can level their skills and what benefits they’ll gain from improved performance. They’ll have an incentive to improve their work ethics and get more compensation from the company.

Benefits of a Compensation Plan

People searching for jobs want to find the right fit for their skills, but compensation is a crucial component. They want to know they’re valued for what they do. The benefits of a compensation plan pay off for your business in several ways.

Attract and Retain Talent

A stellar compensation plan stands out compared to similar companies. If you and a competitor need salespeople, you might get some of the same applicants.

You can ensure the applicant accepts your job if your compensation is better than the competition. You might offer a base salary plus commission or profit-sharing in the company.

The best compensation plan doesn’t only ensure you get to hire the best talent. It also means they’re more likely to stay with your company over the years. They’ll appreciate the value of the compensation plan and want to stick with those benefits.

Motivate Employees

Compensation plans motivate employees because they don’t want to lose the benefits they receive.

For example, if you offer an impressive health insurance plan, your employees will work hard to ensure they don’t put their job at risk and lose that benefit since insurance is so expensive to pay out of pocket.

Instead of having employees asking for a raise, they’ll already know what compensation they’d receive with a promotion.

They can strive to reach these goals fueled by their motivation. Employees know what bonuses or profits they can earn if they do their best work, so they’ll stay loyal to your company.

Improve Employee Engagement and Satisfaction

Employees engage more with work when they understand what they’re getting out of it. If you pay a base salary and nothing more, they’ll start to feel like you’re taking advantage of them.

You need to ensure your compensation plan helps them understand how you appreciate their effort, so they’re satisfied with what they receive.

You can also boost engagement with profit-sharing, bonuses, or commissions. When employees increase their work quality and output, they have the chance to make more money.

Instead of feeling undervalued, they’ll understand how their work ethic can improve their benefits regarding financial bonuses or time off.

Increase Productivity

Employees who feel valued will want to be more productive for the company. They understand how the company works and what they need to do to earn their compensation plan, so they learn how to work more efficiently. When employee productivity rises, you’re getting more work for the money you’re putting into your workforce.

On the other hand, employees who don’t think they’re paid fairly will start to look for other jobs. You’ll lose employees that you’ve already spent time and money on onboarding and training.

This turnover will cost your business money, plus it can harm your reputation if the disgruntled employees start to badmouth you.

Align Employee Efforts With Organizational Goals

A compensation plan that requires employee effort and input ensures the individuals’ goals align with your company’s mission. You can directly tie the compensation they can earn to the success of the organization for a win-win situation.

Employees who understand that a job well done means they can get a monetary bonus or time off work will want to increase their efforts to earn this incentive. Therefore, tying their productivity to the overall wellness of the organization can benefit everyone involved.

Types of Compensation Plans

There are different types of compensation plans according to your industry and location. In the United States, insurance is one of the biggest incentives for compensation. In many areas, paid time off is becoming the most important aspect of a hiring package.

Salary-Based Compensation Plan

A salary-based compensation plan prioritizes annual earnings. Employers pay an annual salary for employees they want to retain over the years. Common positions that receive salary-based plans include teachers, doctors, and managers.

Hourly-Based Compensation Plan

An hourly-based compensation plan is most common for part-time and temporary jobs. There’s no need to commit to a full year of employment because the workers get paid hourly.

You need to adhere to your state’s minimum wage requirements and know the definition of overtime for when the employee works beyond their standard hours.

Commission-Based Compensation Plan

Commission-based compensation plans are most common for salespeople. They must meet a specific quota to earn their pay and can earn more as they reach higher goals. You can offer roles that only pay commission or those that offer a base salary plus commission.

Bonus-Based Compensation Plan

Bonuses count as incentive pay, and you can use them to motivate employees based on specific timelines. Many employers offer a year-end bonus, while others pay quarterly or after a project’s completion.

Profit-Sharing-Based Compensation Plan

A profit-sharing plan is a method of incentive pay because the employees make more money when the company does well.

You can choose to pay out the profit shares annually or quarterly. Employees feel invested in the quality of the company’s output, so you tend to have loyal workers with this type of plan.

Stock Options-Based Compensation Plan

Stock options are ideal in many industries because they can grow over time based on the company’s performance in the stock market. Most stock-based compensation plans have a timeline involving withdrawal, typically after three to five years.

Benefits-Based Compensation Plan

Benefits-based compensation plans are the most common, especially in the United States, where insurance is expensive to purchase. Benefits can include health insurance, life insurance, disability insurance, and pension plans.

Key Elements of a Compensation Plan

Though there are various options for compensation plans, each one contains some key elements.

Base Salary

The base salary is the most important part of the compensation plan. Your employees will calculate the gross vs. net pay to understand what they earn.

If it’s not enough to cover their cost of living or makes them feel undervalued, they’ll look for work at companies that pay more on this level.


Bonuses are nice incentives that employees can earn when they reach certain benchmarks. You might offer an annual bonus to thank them for a year of service.

You can pay bonuses when they work for the company for five or ten years. You can even offer a smaller bonus after every successful project the employee completes.

Stock Options

Stock options keep employees invested in the company because they own a share of it. After a set amount of years, typically three to five, the employee can choose to sell what they have.

They’ll get money from the sale, which serves as an incentive to do good work and increase the company’s efficiency, therefore boosting the stock value.


In the United States, benefits are non-negotiable for employment. Individual insurance plans are so expensive that they can quickly decrease the employee’s take-home money to nothing.

Offering a work-based insurance plan lowers the costs for everyone involved. Many people won’t accept a job without benefits, so it’s just as important as the base salary.


A commission is a way employees can earn bonuses on sales, which motivates them to work harder. You can offer commissions on top of the base salary or hire employees who work solely on commission.


Other incentives can include further financial compensation or other perks like paid time off, parental leave, mental health days, and employee discounts.

Creating a Compensation Plan

You understand what to offer in a compensation plan and why. Follow these steps to create a plan that will help you hire and retain the best employees.

Step 1: Conduct a Job Analysis

Understand what you’re asking an employee to do in their role. You can break down each position to see what skills they need to do the work properly. This information will impact their salary.

Step 2: Determine the Compensation Philosophy

Decide what type of compensation plan you’ll offer based on the options above. You can also choose to mix and match several choices, like offering a base salary plus bonuses or profit-sharing.

Step 3: Develop a Pay Structure

The pay structure helps you prioritize certain positions to ensure professionals earn more than unskilled workers. You might also choose to only offer certain benefits to full-time employees, which you can factor into the structure.

Step 4: Conduct a Salary Survey

A salary survey helps you see what other companies are paying their employees. You can compare your job descriptions with competitors and see how much you should offer to ensure applicants want to work for you over anyone else.

Step 5: Determine Pay Increases and Bonuses

Once you have the basic pay structure, you want to build in some incentives. Knowing when you’ll increase pay and distribute bonuses will help you budget for the year. You’ll also be able to explain promotions to employees in a way that motivates them.

Step 6: Determine Employee Benefits

You want to offer benefits beyond the base salary. Find out how much it costs to offer company-wide insurance and pension plans.

See what other perks you can offer, like paid time off, to ensure your employees want to continue working for you over the years.

Step 7: Communicate the Compensation Plan

Hold a meeting, send email alerts, and post information about the compensation plan for the employees. You can also choose to mention these benefits in job listings when you hire for a new position.

Common Mistakes to Avoid When Designing a Compensation Plan

The steps above put you on the right path to creating a solid compensation plan that attracts employees. However, there are a few mistakes you want to avoid during the process.

Lack of Alignment

Your compensation plan should align with company goals. You can’t say you’ll provide a bonus when an employee completes a project but not pay it.

If you position your company as a place that promotes a work-life balance, offer adequate time off. Your employees will notice the lack of alignment and become disillusioned by the organization.


If you plan on monthly payments and annual bonuses, you need to stick to the schedule. Being inconsistent in payouts or other incentives can discourage employees. If they’re not earning what they’re promised, they won’t feel compelled to do their best work.

Regular reviews of the compensation plan can also help prevent inconsistency. You want to ensure you’re offering benefits that rival the competition to show employees they don’t need to find a new job to make ends meet.

Lack of Transparency

Communication is always key in the workplace, but it’s especially crucial regarding compensation plans. You want your employees to know what benefits they get once they’re hired, along with the perks they can earn with good work. If you don’t make this known, they’ll feel like they’re not getting what they deserve.

Inadequate Budget

You want to show your employees how much you value them, but you can’t promise them more money than you have. You need to use your company’s budget as the baseline for any compensation plans you want to offer, so you don’t go into debt.

Frequently Asked Questions

You’ve learned about the different types of compensation plans and what they offer. If you need more information, check out the answers to these frequently asked questions.

How can I ensure that my compensation plan is fair and equitable?

The best way to provide a fair compensation plan is to offer the same general benefits to all employees at a certain level.

For example, all full-time employees get health insurance and a pension plan. The salary of each position can vary depending on the job duties, which keeps things equitable.

How should I communicate the compensation plan to employees?

Clear communication is an unwritten benefit in the workplace. Employees always search for signs their boss wants them to stay, so outlining the compensation plan can help.

Let them know specifics about base pay, then outline possible bonuses and benefits they can earn at their current role or after a promotion.

What are some best practices for reviewing and updating the compensation plan?

You should regularly review the compensation plan with the human resources department. See what other companies in the same industry offer their employees, and ensure you provide the same foundation. You can then determine what bonuses or perks might help you attract and retain the best talent.

How can I balance the need to offer competitive compensation with the need to manage costs?

Balancing compensation with operational expenses is a crucial task. You need to pay employees what they’re worth, but you don’t want to blow the budget.

However, prioritizing employees will pay off in the long run because they feel valued and stay with the company. Profit-sharing can help you minimize costs while ensuring engaged employees.

Wrapping Up

There are many types of compensation plans that vary according to your industry and employee type. You can choose to pay hourly wages or annual salaries.

You might offer your employees an insurance package, paid time off, or a pension plan. These benefits add up to compile a comprehensive compensation plan that draws in the best talent in your field.

If you have any questions about compensation plans, leave a comment below. Getting feedback about real-life applications of this advice is crucial to creating a working environment that benefits the employees as well as the company.

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