As the economy staggers into a recovery, many employers are continuing the salary and wage reductions or freezes that they implemented during the recession. As a result, many employers continue to forgo annual raises and, instead, will reward employees through year-end bonus compensation. It is important that employers properly characterize such bonus pay as either "discretionary" or "non-discretionary" before any payments are made, since there may be contractual and/or overtime obligations associated with non-discretionary bonuses that could create future monetary liability to the employer.[1]

A "bonus" is compensation paid to an employee in addition to the employee's regular wage or salary and is typically intended to reward employees for performance above and beyond normal expectations. The term has been defined as "[a]n addition to salary or wages normally paid for extraordinary work. An inducement to employees to procure efficient and faithful service." Duffy Bros. v. Bing & Bing, 217 App.Div. 10, 215 N.Y.S. 755, 758 (1926).

Bonuses can be in the nature of, for example, a gift, profit/gain sharing, attendance or performance awards, referral awards, safety awards, and/or awards for providing usable suggestions to the employer. As previously noted, bonuses may be discretionary or non-discretionary. Discretionary bonuses are gratuitous payments by the employer (i.e., there is no promise of payment) to employees. The quintessential example of a discretionary bonus is the nominal holiday gift, such as the proverbial Christmas turkey described by Dickens, or the modern-day equivalent – the gift card, given by employers to employees at the end of the year.

In order for the bonus to qualify as discretionary, the employer must maintain complete discretion over whether any payments will be made and, if payments are made, what amount will be paid to each employee. Discretionary bonuses are not tied to individual employee performance or meeting an individual production goal or attendance requirements and should be announced shortly before the close of the bonus period. In other words, the employees do not anticipate receiving a bonus and their continued employment or performance during the year is not motivated by the anticipation of a year-end bonus payment.

Truly discretionary bonuses do not generally create current or future contractual obligations for employers. As such, employees who are terminated or resign prior to the payment of a discretionary bonus are not legally entitled to any bonus payment. Further, discretionary bonuses are not includable in the overtime calculation for non-exempt employees (the overtime implications of non-discretionary bonus pay are discussed later).

However, when an employer regularly provides year-end "discretionary" bonuses and the amount of the bonus varies little from year to year, the employer may be inadvertently creating a non-discretionary bonus plan that may be legally construed as an implied promise to pay bonuses in future years. To avoid such unintended consequences, employers may wish to exercise their discretion and vary the timing and amounts of the discretionary bonuses from year to year.

On the other hand, non-discretionary bonuses are based on objective criteria, such as company profitability and/or employee performance/productivity goals, and are considered a unilateral promise by the employer to pay the bonus to employees once specific results are achieved. Generally, non-discretionary bonuses are considered a matter of contract between the employee and the employer. As such, most state courts and administrative agencies will enforce the terms of a non-discretionary bonus plan, including provisions that condition payment of the bonus on the employee's active employment on the date that the bonus is paid.

However, since the common law relating to the enforcement of contracts varies from state to state, employers should consult with counsel to determine whether there are nuances in state law that must be considered when implementing a non-discretionary bonus plan. For example, in California, where the promise to pay a bonus is not expressly conditioned on continued employment, an employee whose employment is terminated (even voluntarily) may be entitled to some or all of the bonus if all other applicable conditions have been satisfied. Lucien v. All States Trucking, 116 Cal.App.3d 972, 975 (1981). In order to avoid any misconceptions by employees regarding the criteria used to determine when a non-discretionary bonus is earned, it is advisable to put the bonus plan in writing and have the employees sign-off on the plan.

In addition, the payment of a non-discretionary bonus to non-exempt employees may create additional overtime liability for employers. Pursuant to the Fair Labor Standards Act and state law, non-discretionary bonus payments must be included in the calculation of the "regular rate" for overtime purposes. 29 CFR 778.208-209. There is little difficulty in calculating overtime compensation if the bonus covers only one week or a single pay period in which it is paid. In these cases, the amount of the bonus is merely added to the other earnings of the employee (except statutory exclusions) and the total divided by total hours worked each week.

However, where the bonus payment is meant to cover an extended (quarter, semi-annual, or annual) period, the bonus payment must be apportioned back over the workweeks of the period in which it was earned. The employee must then receive an additional amount of overtime compensation for each workweek that he or she worked overtime during the period allocable to the bonus. Employers have several options for calculating the additional overtime, and they should consult with counsel to determine which approach is appropriate for them.

While the payment of year-end bonuses, especially in tough economic times, can engender employee loyalty towards and employer and encourage increased productivity, bonus payments, especially non-discretionary bonus payments, can create additional legal and monetary liability, as well as administrative headaches, for employers. Accordingly, employers should carefully craft and implement bonus plans with the assistance of counsel and make sure that the bonus plans are clearly communicated to employees.