What Is Compensation? | Compensation meaning and List of Allowances

What Does Compensation Mean?

You give your employees a regular paycheck. But, you might also give other wages to your employees. Do those other wages count as compensation? What is compensation?

Employee Compensation Definition:

Compensation is the total cash and non-cash payments that you give to an employee in exchange for the work they do for your business. It is typically one of the biggest expenses for businesses with employees. Compensation is more than an employee’s regular paid wages. It also includes many other types of wages and benefits.

Types of compensation include:

what is compensation? different types with illustrations

What is base pay?

Base pay is the initial pay you give your employees. The base pay rate is essentially the minimum amount an employee can expect to receive before taxes and other deductions.

Base pay includes an employee’s base salary or hourly wages. It also includes shift differentials and pay for special assignments.

Base salary vs. total compensation

An employee’s base pay does not include compensation that might raise the wages above the base level. For example, bonuses, overtime, and commissions are not part of base pay. These types of pay are included in the employee’s total compensation.

Is base pay gross or net wages?

Gross pay is the amount an employee earns before taxes and other deductions are subtracted. Net pay is the amount the employee takes home after everything is subtracted.

An employee’s base compensation is part of both gross and net wages. But, gross and net wages might include other compensation too, such as overtime wages. An employee’s base pay might be their gross wages if there are no other compensation types to add.

How to determine compensation of employees

There are many ways to determine an employee’s compensation. No matter how you determine employee wages, you should consider internal equity. Internal equity is when you compare the positions in your business to ensure fair pay.


Do research on what other businesses pay their employees. Compare your business to other businesses in the area. What are other employees paid in your area? Also, make sure you pay attention to employees who have similar job titles and duties that your employees have.

You can survey other businesses that are similar to your business. You can also check websites where employees self-report their wages.


If a particular employee excels at their job, you can pay them increased wages. Or, you might pay an employee more if they received more education or advanced training related to their job.

Previous wages

You base an employee’s wages off their wages at their previous job. You might match the previous wages or offer an increase.

Available funds

What does compensation mean for your bottom line? You need to calculate carefully how much you can spend on employees. When determining how much an employee costs, remember the costs of taxes and benefits. Before you offer a job or pay raise, make sure the compensation plan will fit in your budget.


By offering desirable benefits, you might be able to offer a lower base pay to employees. You need to know what benefits are the most desirable in your area and industry. Employees often heavily consider employee benefits packages when looking for a job.

Compensation regulations

Compensation is governed by many local, state, and federal tax and employment laws.

You need to abide by federal minimum wage laws, which are governed by the Fair Labor Standards Act (FLSA). Many states and some cities also have their own minimum wage. You must pay all employees at least the prevailing minimum wage.

You must follow other FLSA rules as well. The FLSA has rules on child labor (including the child minimum wage and hiring teens), and overtime wages.

You also have equal employment opportunity responsibilities. You should give equal pay to employees who do the same work.

Compensation can be complicated when it comes to taxes. You will withhold taxes from some types of compensation, but not from others. Make sure you know what taxes apply to each type of compensation.

For example, you will withhold taxes on tips, regular wages, overtime wages, and commissions. You will also withhold taxes from bonuses, but you will calculate the taxes differently. You won’t withhold any employment taxes for benefits.

There are also many other federal, state, and local laws that govern compensation. Make sure you understand your responsibilities before hiring employees.

Curious about the other types of employee compensation? Download our FREE guide, Understanding Compensation: Employer Responsibilities and More, to get the lowdown.

If you are looking for a low-cost way to pay your employees, try Patriot’s online payroll for small businesses. Get started today with a no-obligation free trial.

This article is updated from its original publication date of  7/9/2012.

Stay up to date on the latest payroll tips and training

You may also be interested in: