What Is Variable Pay, and How Exactly Does it Work?

As an employer, you want to see your employees succeed and grow along with your company. To reward employees for great performance, you may decide to give them variable pay. But, what is variable compensation exactly?

What is variable pay?

Variable pay, also sometimes referred to as incentive pay or commission, is a way to compensate employees beyond hours worked and encourage employees to meet objectives. It can either be a percentage (e.g., 5% based on sales) or a set dollar amount (e.g., $100 per quarter).

Typically, employees receive variable pay based on their job performance. However, it can be based on other factors, like sales, referrals, and the company’s profits. 

Depending on your business’s preferences, variable compensation can supplement an employee’s base pay or be part of their total pay. However, most businesses choose to pay this type of compensation in addition to an employee’s base pay.

So, what’s the difference between variable pay and base pay? Base pay is a fixed amount and paid out regardless of performance or goals met. Variable pay is not guaranteed. Instead, it’s based on whether the employee met a certain goal or how they performed during a period.

From customer service to sales, variable pay is common in a variety of industries. Check out some examples of variable pay:

  • Performance bonuses
    • Employee can receive a bonus twice a year based on job performance
  • Sales commissions
  • Referral bonuses
    • Employee receives a percentage or dollar amount for referring employees or customers
  • Profit sharing
    • Company reaches certain profit amount and distributes a portion of profits to employees

Types of variable pay can vary from business to business. If you choose to establish a plan, you can choose how employees earn variable pay.

Is variable pay subject to payroll taxes?

Because variable pay is a type of compensation, it is subject to payroll taxes. Withhold the proper amount of taxes from each employee’s variable pay. To help with calculations, consider getting payroll software.

If you want to pay a flat amount to an employee for variable pay (e.g., $100 gift card), you can gross up the amount by using software or a calculator.

variable pay

Pros and cons of variable pay

There are plenty of benefits to offering variable pay to your employees. However, there are a few downsides, too. Check out a few pros and cons of variable pay below.


  • Boosts employee retention
  • Increases productivity
  • Motivates employees
  • Helps reach business goals


  • Plan may not apply to all employees 
  • Can be expensive
  • Potentially causes tension on the team

Before you decide to implement a variable payment plan, weigh the pros and cons. Do your research to find out if variable pay is the right fit for your business. 

Need an easy way to pay employees variable pay and other types of compensation?

Learn which payment method is best for your business with our FREE guide Compare Different Methods of Paying Employees.

Variable pay examples

Want to see variable payments in action? Let’s take a peek at a couple of examples, shall we?

Example 1

A manager receives a salary and can earn a $100 bonus for each month his team does not have a safety violation.

Throughout the year, the manager’s team only had two months with safety violations. So, the manager received $1,000 ($100 X 10) in variable pay bonuses for the year. 

Example 2

A car saleswoman makes 2% commission for each car she sells. During the month, the saleswoman sells 10 cars that are $30,000 each. 

From the commission, the saleswoman makes $6,000 [($30,000 X 10) X 0.02] in commission for the month before taxes. 

Setting up a variable pay plan

Thinking about creating a variable pay plan for your company? Before you can implement a plan, you need to follow a few steps.

To establish a plan at your company, do the following:

  1. Consider the target and goals you’d like to hit and determine your incentives based on your goals
  2. Brush up on Fair Labor Standards Act (FLSA) requirements to ensure your business is compliant with variable compensation and overtime rules
  3. Write a variable pay policy and include every detail about your plan for employees
    1. Which employees are eligible for variable pay
    2. How much variable pay the employee can earn and if there’s a cap
    3. What employees can do to earn variable pay (e.g., refer other employees)
    4. When and how employees will receive earned variable pay
    5. Whether the variable pay varies on outside factors, like company sales
  4. Have employees sign a copy of the policy and keep it in your records

To track progress and see if the incentive pay is working well for your company, monitor employees’ performance over time. Consider meeting with each employee to go over results and get feedback about the plan. And, use employee feedback to improve your variable compensation plan.

This article has been updated from its original publication date of March 9, 2012.

This is not intended as legal advice; for more information, please click here.

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