Variable pay: How it works and examples

Variable pay is a compensation strategy employers use to incentivize employees by offering them more than just their base pay. While there are several approaches to variable pay, all share the same goal: rewarding performance. A well-structured variable compensation plan not only motivates employees to excel but also provides additional income while contributing to the company’s success.

In this guide, we’ll explore the different approaches to offering compensation that’s paid based on employees’ performance and highlight the main distinctions between variable and traditional pay structures.

What is variable pay?

Variable or incentive pay is compensation given to employees based on their performance. It’s awarded to them on top of their base pay and can be a highly motivating reward. It’s often a cash incentive, like a bonus or commission, but variable pay can also take other forms, like profit sharing, gifts, vouchers, or holidays. The amount is usually determined by the performance of the employee and the organization. 

Variable compensation provides numerous advantages: promoting hard work, acknowledging success, retaining high-performance employees, and attracting top talent. 

How does variable pay work?

To maximize the benefits of variable pay, employers should be upfront with employees about the structure and what they could earn. Is it an all-expenses-paid trip to the Bahamas or a performance bonus at the end of the year? People need to know what they’re working toward.

Bonuses are often paid out as a percentage of the base pay. This percentage usually depends on the employee’s position and department. For example, C-suite execs may get more incentive pay than those in marketing.

To calculate the pay mix (the fixed and variable components of an employee’s compensation), use this formula:

(variable pay / total compensation cost) x 100 = variable pay %

Examples of variable pay

Employers have various compensation models to choose from. Each serves different business models, incentive structures, and workforces.

1. Commission pay

Commission is calculated as a percentage of the revenue an individual generates for a business. It’s often used for salespeople. Typically, it’s a flat percentage of their sales, but employers can use a tiered commission structure. As a tiered, commission-based variable pay example, an employee might make 7% on all sales up to $5,000, 10% on sales from $5,001–$10,000, and so on.

The ratio between sales commission and base pay varies depending on the job. Some professions, such as real estate agents, earn more in commission than on their base salary (if they receive one at all). In contrast, a sales rep might get a decent base salary and expect to earn an additional 10–15% in commissions.

2. Bonus pay

A bonus is a lump sum of money that employers pay, usually based on the company’s and employee’s performance. It differs from a commission as it isn’t directly tied to how much money an individual generates for the business. Instead, this incentive is granted when company-wide goals are met or the employee has gone above and beyond.

Bonuses can also be tiered, like commissions. Your team members may earn 20% of their salary as a bonus for meeting their targets and get 25% if they exceed those objectives. Bonus percentages are often larger for high-ranking employees.

Employers can also pay bonuses for long-serving team members, new hires, and successful referrals.

3. Profit sharing

Profit-sharing plans are used to retain employees and attract new talent. This variable pay type gives workers a portion of the company’s profits each quarter or year, typically in proportion to their base salary. It may only be granted when the company hits certain milestones. 

You decide how employees receive their profit share. The earnings may be disbursed as a retirement plan, an employee trust, or a direct payment. You could allocate the same percentage across the board or reward specific roles, teams, and departments differently.

4. Differential pay

Differential pay is additional compensation given to hourly workers for exceptional or irregular circumstances. For example, if a rush order needs to be completed by a tight deadline, you might offer night shifts. To incentivize workers to come in after hours, you could include differential pay as part of their compensation.

Traditional pay vs. variable pay

Traditional pay is based on a set hourly wage or salary. It may include a base salary, overtime, allowances, and a fixed 13th-month check. This type of pay rewards employees for doing their jobs.

Everyone needs to earn a living, but a salary won’t necessarily drive people to exceed expectations. Conversely, variable pay can motivate people to achieve more than the basic role requirements. 

Traditional payment is always money administered via check, direct deposit, or cash, whereas variable incentives can be money, stocks, gifts, or vouchers. For this reason, variable pay is more complicated during tax season. Differential payments may be allocated alongside regular wages or as a bonus at set times of the year. 

Traditional and variable pay have different purposes. The former simply exchanges money for labor. The latter incentivizes employees to work as hard as possible and increases to compensate them for their effort.

Who receives variable pay?

Anyone in a company can receive variable pay, but some are more likely to see a bonus check than others. The following team members typically receive variable pay: 

• High performers: People who work exceptionally hard and have the results to prove it. These employees often put in overtime and work with speed and accuracy.
• Risk-takers: Some jobs are riskier than others, such as specific roles in the construction industry. Employers may pay extra through performance-based variable pay or differential pay for this hazardous work.
• Sales representatives: If sales representatives meet sales targets, they’re often rewarded with performance-based compensation, profit sharing, or commissions. Variable pay motivates employees to reach goals and gives them a sense of ownership over their work.
• Employees in leadership roles: Leaders hold more responsibility and are frequently rewarded with variable pay. Leaders can earn commissions, performance-based pay, or a profit share.

Pros and cons of variable pay

Here are the benefits of variable pay: 

• Retaining high-performing employees: Generally speaking, the highest-performing employees earn more variable pay, motivating them to stay with the business.
• Balancing salaries and linking compensation to business performance: Salaries can be a huge expense for companies, eating up funds during quiet periods. By linking compensation to business goals, you can reward employees fairly when the business does well without worrying about cash flow.
• Enhancing competitiveness in the job market: Workers deserve fair pay, and high performers have high variable pay expectations. Including variable pay in an employee’s total compensation helps you attract top talent.

The downsides to variable pay include the following:

• Poorly structured systems encourage feelings of inequity: If a system doesn’t reward employees equitably, it can lead to unfair workplace practices and create an unhappy workforce.
• Oversized bonuses can stress organizational budgets: If your combined compensation packages (variable rewards combined with base salaries) are too costly, you could overextend your budget.
• Recency bias could unfairly impact pay evaluations: No one is at their peak every day. A high-performing employee may hit a slump or experience personal issues that affect their job performance. Employees who are rated only on recent contributions and not on overall performance may not be rewarded fairly.

Simplify variable pay with Oyster’s Global Payroll

International payroll administration can be complicated, especially with regional laws and laborious manual processes. Variable pay adds to this challenge, making a streamlined solution a necessity.

With Oyster’s Global Payroll platform, you can consolidate payroll operations for your global team into a centralized hub, ensuring accurate and compliant payments. Oyster helps you reward employee performance so you can focus on growing your business.