For decades, many employers across California relied upon established federal law governing the calculation of overtime compensation on bonuses. Under federal law, the same set of rules apply to flat sum bonuses (i.e., set bonus amounts that cannot increase with additional productivity or employee effort) and other bonuses.

That all changed earlier this month when the Supreme Court of California decided Alvarado v. Dart Container Corporation of California. The decision transforms the method for calculating overtime under California law when employees receive flat sum bonuses. The court’s decision represents a significant development for employers that pay bonuses and will likely require employers operating in California using flat sum bonuses to revise their pay practices.

Background

Under California law, when an individual receives a nondiscretionary bonus, the bonus payment must be included in the employee’s “regular rate of pay” for purposes of calculating overtime. The question in Alvarado was how this calculation should be made with respect to flat sum bonuses. The flat sum bonus at issue was a $15 attendance bonus that employees received when they worked weekend shifts.

The California Division of Labor Standards Enforcement (DLSE) has long taken the position that California requires a special, more expensive overtime calculation for flat sum bonuses. According to the DLSE, to protect against dilution as employees work more overtime, flat sum bonuses are to be divided only by straight-time hours and then multiplied by one-and-one-half (or two in the case of double time) to determine overtime premiums on these bonuses. By contrast, the DLSE opined bonuses that increase with more effort or production (for example, a $5 bonus for every 100 widgets made) could instead by divided by all total hours worked and multiplied by one half (or one in the case of double time) to determine the overtime premium owed.

Federal law, derived from the Fair Labor Standards Act, does not have any unique formula for flat sum bonuses. And until this ruling, the DLSE’s position on flat sum bonuses was never actually endorsed by a California court. In fact, the court of appeal in Alvarado rejected the DLSE’s position and applied federal law to flat sum bonuses. As a result, many employers relied on federal law to calculate overtime when employees received these bonus payments, using the larger divisor of total hours worked and thus resulting in smaller overtime payments relative to those under the DLSE’s formula.

The California Supreme Court’s Ruling

The law has changed. The California Supreme Court unanimously reversed the court of appeal’s ruling and adopted the DLSE’s rule on flat sum bonuses. Although the court did not believe it was bound by the DLSE’s guidance, the court nevertheless found the DLSE’s reasoning persuasive. The court reasoned that using the DLSE formula to calculate overtime on flat sum bonuses furthered California’s public policy of discouraging overtime work. Because flat sum bonuses do not increase with more hours worked, the court concluded that to allow employers to divide by total hours worked in calculating overtime would encourage employers to assign more overtime. In such a case, the more overtime an employer assigned, the larger the divisor would be and the less value the bonus would have relative to each hour worked.

The rule adopted by the supreme court requires employers, in calculating overtime when employees receive flat sum bonuses, to divide the bonus only by straight-time (i.e., non-overtime) hours to determine overtime compensation on the bonus. The net arithmetic effect is that the formula adopted by the California Supreme Court results in a payment of more than three times as much overtime compensation on the bonus as the federal law formula.

Implications for Employers

The Alvarado ruling has far-reaching implications for employers that provide bonus or incentive payments in California.

For any employer that pays a flat sum bonus, the decision likely means that the employer will need to revise its pay policies immediately to comply with the California Supreme Court’s ruling. At the very least, employers that pay bonuses should consider evaluating their payment policies and calculations to determine if they remain lawful after Alvarado.

In addition to policy revisions, the ruling has significant implications for employer wage-and-hour liability. Importantly, the California Supreme Court rejected the argument that its formula should only have prospective effect. Its formula will therefore apply retroactively to flat sum bonus payments. This means that if an employer previously relied on the federal formula, its past flat sum bonus payments were likely unlawful.

The effect is not simply that employees who received such bonuses were underpaid. On top of the underpayment, employers could be subject to significant penalties. In addition to unpaid wages, employees in wage-and-hour lawsuits typically seek derivative penalties such as wage statement penalties ($50/$100 per pay period), waiting time penalties (up to 30 days of wages), and civil penalties under the Private Attorneys General Act (PAGA) ($100/$200 per pay period per violation). Given these potential penalties, even a small underpayment could give rise to far-reaching exposure that exponentially increases liability.

Moreover, there are many types of flat sum bonuses that are common across industries. They range from attendance bonuses like those at issue in Alvarado to safety bonuses, project-completion bonuses, referral bonuses, job retention bonuses, on-call stipends, and bonuses for earning a degree or technical certification. Therefore, the decision could arguably impact many bonus payments made for a variety of purposes across a broad array of industries.

Finally, the ruling will likely lead to significant administrative challenges for employers—an issue that employers may want to consider. Employers that pay flat sum bonuses like an attendance bonus but also make other incentive payments like commissions will have to work with their payroll providers to ensure that two different formulas are applied to the different payments. Since the flat sum rule is unique to California, it will also result in employers with multistate operations having two different calculations for the exact same type of bonus payment, depending on the state. Employers may want to have these conversations with their payroll providers to ensure technical compliance with the law.

Silver Linings?

For employers, there were not many positives to take away from the Alvarado ruling. But, there were a few potentially helpful comments hidden within the supreme court’s ruling.

First, the court confirmed prior law finding that informal positions taken by the DLSE in its enforcement manual are effectively “underground regulations” and not subject to deference. Of course, that does not mean the California Supreme Court will refuse to follow DLSE opinions. After all, it adopted the DLSE’s rule in Alvarado. However, this statement is helpful in confirming that the DLSE’s published but informal opinions will not be given binding deference by courts.

Second, in a footnote, the court explicitly limited its decision to flat sum bonuses “comparable to the attendance bonus at issue” in the case. The court noted that “other types of nonhourly compensation, such as a production or piecework bonus or a commission, may increase in size in rough proportion to the number of hours worked,” and thus might warrant a different analysis. Therefore, the court did not explicitly extend Alvarado to other types of bonuses but instead left ambiguity as the scope of its decision. Employers may be able to rely on this footnote in distinguishing other bonuses from Dart’s attendance bonus. For example, the Alvarado court reasoned that a flat sum attendance bonus could encourage an employer to assign more overtime, given that the bonus does not increase as more hours are worked. On the other hand, flat sum referral bonuses may be included in the regular rate of pay, depending on the conditions. However, a referral bonus has no conceivable connection to hours worked and certainly does not encourage an employer to assign overtime. Employers may be able to capitalize on these distinctions and narrow the potential scope of the supreme court’s ruling. Only time will tell how this strategy plays out.

Third, in a concurring opinion, Chief Justice Cantil-Sakauye noted that the DLSE could have avoided “uncertainty” over the prior law had an interpretative regulation on this subject been promulgated through formal rulemaking. The DLSE’s flat sum bonus interpretation was only present in the agency’s enforcement manual, and because it was not subject to any rulemaking procedure, it had no binding effect. The chief justice characterized this uncertainty as regrettable. Although these words do not change the result of Alvarado, they may prove helpful in defending future litigation based on bonus payments. Certain penalties under California law, like waiting time penalties, require a showing of willfulness. Others, such as civil penalties under PAGA, are subject to reduction in the court’s discretion. Given the uncertainty over the law and the existence of federal law supporting a completely different flat sum bonus calculation, employers may be able to use the concurrence to argue against imposition of these penalties.

We suspect that Alvarado will give rise to a flood of litigation in the coming months. As this litigation develops, hopefully courts will shed light on these lingering questions. In the meantime, employers should consider carefully evaluating their bonus payments to ensure compliance with the supreme court’s decision and working with payroll in updating their flat sum bonus formulas.