A bonus is “something given or paid in addition to what is usual or expected” according to The American Heritage® Dictionary of the English Language. The Columbia Encyclopedia informs us that the “wage incentive was designed during the late 19th century not only to increase production but to reward the more skillful and more energetic workers.” In other words, a bonus is a premium paid above and beyond standard compensation to reward high-achieving employees and to encourage them to continue such achievement with the company in the future.

All too often, however, despite employment policies explicitly stating otherwise, many employees have come to view year-end bonuses as a usual and expected part of their compensation, viz., an entitlement rather than, well, a bonus. The issue of determining year-end bonuses carries important employment law implications under the Fair Labor Standards Act (“FLSA”), state wage laws, as well as the laws against discrimination and the common law. This may be particularly true for employers whose employees, rightly or wrongly, have come to look at “bonuses” as part of their standard compensation.

The FLSA

The FLSA requires an employer to take certain types of bonuses into account when determining a non-exempt employee’s “regular rate of pay” which, in turn, is used to calculate an employee’s overtime pay. For overtime purposes, the FLSA distinguishes between discretionary and non-discretionary bonuses. Truly discretionary bonuses are not part of a non-exempt employee's “regular rate of pay”, and therefore do not impact the overtime compensation due them. On the other hand, non-discretionary bonus payments must be included in the overtime calculation for all non-exempt employees working more than 40 hours in any workweek covered by the bonus.

In general, application of the following factors will determine whether or not a bonus is part of a non-exempt employee's “regular rate of pay” for purposes of the FLSA:

  • Is the payment a productivity bonus? Productivity bonuses based on performance or used to encourage productivity are counted as earnings, and must be included in the employee’s regular rate of pay.
  • Is the payment discretionary? Discretionary bonuses are usually not considered part of an employee’s regular rate of pay.
  • Is the payment contractually required? Bonuses paid pursuant to contract are included in the regular rate of pay because such bonuses are not “discretionary.”
  • Is it a special occasion bonus such that it is in the nature of a gift made at Christmas time or other special occasion? Such a bonus would be excluded from the regular rate calculation so long as it is actually a gift or nature of a gift. Caveat: If the payment is so substantial that it can be assumed that employees consider it a part of the wages for which they work, the bonus cannot be considered to be in the nature of a gift.
  • Was the bonus announced in advance? If a bonus is announced in advance, the announcement could be considered a promise to pay, which might increase the likelihood of the bonus being included in the regular rate of pay for FLSA overtime calculations.

New York State Labor Law

Regardless of FLSA issues, employers are obligated under various state labor laws to pay the earned wages for all employees (and in New York "executives" are deemed to be employees covered under the statute). In New York, it is often litigated whether a bonus is considered a wage under New York’s Labor Law (defining wages as “earnings of an employee for labor or services rendered, regardless of whether the amount of earnings is determined on a time, piece, commission or other basis”) and thus must be paid unconditionally as remuneration for the employee’s labor.

New York courts hold that a bonus plan is excluded from the Labor Law’s definition of wages if: (1) payment of the bonus was “entirely discretionary”, and (2) payment was not predicated on the employee’s “own personal productivity” but “solely upon his employer’s financial success.” Where a bonus fails to constitute a wage under the statute, any forfeiture of bonus as a result of the employee’s termination of employment, will not be deemed a violation of New York Labor Law. The same has been applied to equity-based bonus compensation plans, which were unvested, deferred, and dependent on the firm’s “overall success” and not simply on the employee’s “personal productivity”, and held to be outside the scope of statutory wages.

Common Law and Statutory Claims

Outside of unique instances where the terms of a bonus plan are expressed as “contractual” or based on a specific formula (e.g., linked to individual targets achieved), bonus plans are otherwise likely to be “discretionary”. As a general rule, an employee has no legally enforceable right to receive bonus compensation, or a specific sum as a bonus, if the incentive plan is discretionary. However, employers still need to be aware of potential claims under contract and discrimination laws arising from the payment or non-payment of bonuses.

Being cognizant of whether a bonus determination implicates discriminatory treatment proscribed by such statutes as Title VII of the Civil Rights Act of 1964, the Equal Pay Act, the Age Discrimination in Employment Act (ADEA), the Americans with Disabilities Act (ADA), the Family and Medical Leave Act (FMLA), and their state and local counterparts, therefore, should be an important component of the process. Although typically a claim may involve female employees performing substantially equal work as male employees but purportedly receiving lower bonus awards, claims may also arise where the employer prorates a bonus because of absences or decreased productivity due to protected leave of absence. In order to avoid any discrimination claims with respect to bonuses, employers should:

  • Base employee bonuses on objective business criteria such as productivity or pre-set performance standards. Employers who wish to prorate an employee’s bonus due to his or her absences or decreased productivity would be prudent to clearly describe the specific productivity standards upon which the bonus is based.
  • Document the reasons supporting a person’s discretionary bonus and ensure that it is consistent with that employee’s performance evaluations.
  • Provide discrimination avoidance training for those supervisors and managers who are involved in the bonus-determination process.
  • The employer should review any bonus award plan to see if there were any unintended discriminatory effects (such as African American employees receiving less than Caucasian employees or female employees receiving less than male employees) and take the necessary steps to review the process and either rectify any disparities or revise the system to avoid these effects the following year.

You've probably observed somewhat of a tension after reading the above: For FLSA purposes, the greater the unfettered discretion, the greater likelihood the bonus will be excludable from the regular rate of pay. However, for Title VII purposes, the greater the unfettered discretion, the greater the potential for being accused of discriminatory intent (e.g., because of less reliance on objective benchmarks). Employers should weigh the costs/benefits and determine how important it is for the company to exclude bonus payments from the regular rate of pay for non-exempt employees.

Various decisions by the courts and arbitrators have also determined that an employer must exercise its discretion in good faith and on reasonable grounds. If an employee meets his bonus criteria an employer should be prepared to establish reasonable grounds for not paying the bonus if it is to show that it has exercised its discretion in good faith. An employee may also try to assert a claim under an “implied” contract theory if the employer has by custom and practice paid bonuses to other employees who have similarly performed over the year. Although past practices alone do not imply an agreement to continue such practices indefinitely into the future, this type of claim is common in the financial services industry where some employees attempt to argue that their year-end bonuses comprise an integral component of their annual compensation.

Even where the employer retains absolute discretion, it is always good practice to be able to support a decision to withhold a bonus based on rational and legitimate business reasons. As with the potential for discrimination claims, such claims can be avoided by reinforcing the discretionary nature of the bonus (making it clear in all written bonus documents), attaching certain criteria to receipt of a bonus (such as continued employment) and basing these decisions on objective business standards such as employee and employer performance.

Considerations for Employers

During this recession involving personnel and labor expense reduction, employers should be aware of the ways in which current and former employees may seek to recover bonus compensation even where the employer had expressly retained a discretionary policy. At the outset, the company should review what, if any, contractual obligations it has under employment agreements and workplace policies, if applicable. If the company has retained and exercised a discretionary policy, employers should nevertheless be able to articulate an objective and reasonable decision, while also being cognizant of employment laws concerning wage, hour, discrimination, and potential common law claims.