Few things break the trust between employer and employee more than payroll errors.

Mistakes happen. Whether big or small, they can damage your reputation, your relationships, and your bottom line. You’ll struggle to regain your employees’ trust; you might even lose them altogether.

Then there are fines and penalties. What a nightmare! Luckily, there are ways to ensure your staff is paid correctly. Ideally, you always get your payroll right on the first go, but unforeseen circumstances can sometimes make that impossible. 

And when those situations arise, you have one solution remaining: retroactive pay. 

This article breaks down exactly what retroactive pay is, how to calculate and issue it, and how to avoid having to in the first place.

What is Retro Pay?

Think of retro pay as compensation. It’s money you owe employees for work they’ve already done but weren’t paid correctly for the first time. For your employee, it might be a welcome surprise! You’re saying, “Hey, we messed up and didn’t pay you correctly before, but we’re making it right now.”

For you, it might be a bit more of a headache. Hopefully, you have reserved resources to fix errors, but if you don’t, you could have difficulty paying fines and making things right with your employees.

Retro pay comes into play for various reasons. 

• Payroll errors: From clerical mistakes and technical glitches to misinterpretation of contracts and agreements, these errors could lead to employees not receiving their proper paychecks.
• Underpayment: When an employee is consistently paid less than an agreed-upon salary due to misclassification of job roles, failure to adjust pay rates or administration oversights.
• Overtime miscalculations: It’s easy to lose track of overtime hours with complex factors like shift differentials, bonus payments, or commission-based earnings are in play.

Related Read: Common Overtime Mistakes To Avoid 

• Missed bonuses or raises: It’s easy to overlook bonuses or raises promised as part of employment terms or performance incentives.

Retro pay can rectify the above situations, ensuring that employees are fairly compensated. Mistakes can be forgiven if rectified promptly and help maintain transparency in the employer-employee relationship.

1. What’s the Difference Between Retro Pay and Back Pay?

Though we often use the words interchangeably, there are subtle differences between retroactive pay and back pay. Retroactive pay is a type of compensation provided when there’s a difference between what an employee should have been paid and what they were actually paid.

For example, if you give an employee a raise and it was supposed to start in January, but the new rate wasn’t applied until March, they would receive retro pay to make up the difference for January and February.

On the other hand, back pay is a type of compensation provided when an employee was not initially paid for work they should have been paid for.

For example, if your employee works overtime, but the overtime hours weren’t credited on the most recent pay run, they would receive back pay to rectify your oversight. Back pay also covers situations such as wage recovery after wrongful termination or in case of late payments due to administrative errors.

Related Read: Payroll Trends to Look Out For

2. How to Calculate Retroactive Pay

Retro pay calculations for hourly and salaried employees differ. Still, both focus on the difference between what was actually paid and what should have been paid based on hours worked, rates, and other compensation.

The two main circumstances for hourly employees are overtime and wage discrepancies.

• Overtime: If you pay your employee for overtime hours at their regular rate instead of the appropriate overtime rate (usually 1.5 times the regular rate), you must calculate the difference and pay your employee retroactively. 

Do this by: multiplying the overtime hours worked by the difference between the regular and overtime rates to find the retroactive pay.

An example would be nice to add here! (10 hours at $40.40 x 1.5 etc

• Wage Discrepancies: If you increase your employee’s hourly wage but didn’t implement the increase in time, you’ll need to determine the retroactive pay owed. 

Calculate the difference by: Establishing the old and new hourly rates. Then multiply this difference by the number of hours worked in the affected pay periods.

Another example would be great!

For salaried employees, most discrepancies occur around annual bonuses and raises.

• Raises: Divide the annual salary by the number of pay periods before and after an incorrectly implemented raise to determine gross pay for each period. Subtract the former from the latter to find the difference. To find the total retroactive pay due, multiply the difference by the number of pay periods for which the raise should have been active but wasn’t.
• Bonuses: If a bonus was promised but not given, it would be retroactively paid. If you miscalculated the bonus, the retroactive pay owed would be the difference between the promised and the actual bonus.
  
  

3. Examples of Retro Pay Calculations

We’ve told you how to calculate retroactive pay, but let’s look at specific examples so you can see the math.

Hourly Employee Overtime: Your employee worked 10 hours of overtime but was paid at their regular rate of $25/hour instead of the overtime rate of $37.50/hour (1.5 times the standard rate). 

• The difference between the overtime and regular rates is $12.50. The retroactive pay would be 10 hours x $12.50/hour = $125.

Hourly Employee Wage Increase: You increased your employee’s hourly rate from $12 to $15, but their wages didn’t reflect the increase for 20 hours worked. 

• The retroactive pay would be the wage difference ($3) multiplied by the number of hours worked in the affected period: $3 x 20 hours = $60.

Salaried Employee with a Raise: You have an employee earning $50,000/year with bi-weekly pay periods (26 per year). You give them a raise to $55,000, but it isn’t applied for 4 pay periods. 

• The gross pay per period before the raise is $1,923.08 ($50,000/26)
• The gross pay after the raise is $2,115.38. ($55,000/26)
• The difference is $2,115.38 - $1,923.08 = $192.30. 
• The retroactive pay owed is this difference multiplied by the 4 pay periods the raise wasn’t applied: $192.30 x 4 = $769.20.
  
  

Related Read: Five Steps for Converting an Hourly Employee to Salary

Salaried Employee with a Bonus: You promise your salaried employee a $5000 bonus, but they only receive $4000. 

• The retroactive pay would be the difference between what was promised and what was given: $5000 - $4000 = $1000.
  
  

4. Legal Considerations

From taxation implications to labor law compliance, let’s see how retroactive pay affects your payroll processes and your workforce.

First, retro pay and back pay have employment tax implications. They’re seen as additional earnings and are subject to taxation. It’s crucial to make your employees aware of this. Of course, the tax treatment of these payments varies based on local tax laws and regulations. Encourage employees to consult with tax professionals or refer to relevant tax guidelines.

Second, as the employer, you must comply with labor laws and regulations governing wage payments in your jurisdiction. Compensation laws and requirements may vary by region, including the timing and calculation of retroactive payments.

When you work with a payroll provider like ConnectPay, our dedicated tax team takes care of these calculations for you. By utilizing your time-tracking solution or by updating your Payroll Specialist with any wage changes or overtime hours, we’ll get your staff paid on time, every time.

Third, in rare instances, you might overpay employees, leading to more compensation than they should receive. You have the right to recover the overpaid amounts but must adhere to legal guidelines.

• Provide notice to the employee and discuss repayment options.
• Obtain employee consent if you want to make deductions from future wages.
• Be fair, transparent, and compliant with applicable labor laws and regulations.

Employees and employers must understand the legal ramifications of retroactive pay. Employees and employers can protect their rights and ensure they receive appropriate and lawful payments by adhering to taxation obligations, complying with labor laws, and following proper procedures for recovering overpaid amounts.

5. Issuing Retro Pay

There are various ways to issue retroactive pay, but the two most common are including it in regular wages or paying it separately.

You can combine retroactive pay with your employee’s current salary if you decide to include it in regular wages. This minimizes administrative work and means you won’t have to conduct separate calculations, adjustments, and payments. Ensure you communicate with your employee and explain how you calculated the retroactive payment to avoid confusion.

You could pay retro pay separately from regular wages, issuing a distinct payment on specific dates. Employees will see a clear distinction between their regular wages and the retroactive payment and understand that the additional amount will compensate for discrepancies. Paying retroactive pay separately will involve more administrative work and potentially delay payments.

Note: If the separate retroactive payment is significant, it could push the employee into a higher tax bracket for that payment period. This may result in a more substantial portion of the payment being subject to taxes.

What’s the best approach? Evaluate the complexity of the calculations, administrative capacity, and the significance of the retroactive payment before deciding. Ensure open lines of communication with your employees.

Answered: What is Retro Pay?

Understanding retro pay is essential for small business owners and employees. When margins are thin, unplanned retroactive payments can be a significant burden. Not to mention the loss of trust payroll errors can cause.

Is there a way to minimize payroll errors? Payroll software is an excellent place to start.

You can manage payroll and tax withholding with payroll software. These tools can accurately calculate retro pay, adjust tax withholdings, and disburse payments. In addition to recording all transactions, payroll software facilitates auditing and compliance.

Regular payroll audits can help detect discrepancies early and prevent the need for large retroactive payments. This proactive approach can save time and resources in the long run.

A step up from payroll software is letting a payroll provider do the hard work for you. Payroll providers can offer advice based on your specific situation, considering the relevant state and federal laws. At ConnectPay, we take care of payroll and anything payroll touches, such as taxes, workers’ comp, and benefits.

You’ll always reach a human at ConnectPay, and we provide connections to local experts who can optimize your payroll processes.

Let us take on the burden so you can get back to running your business. Get connected with a free consultation today!