How Much to Pay Employees: Legal, Market, and Budget Factors

Many employers, especially those who have recently started their business, often ask themselves, “How much should I pay my employees?” The answer is that this is a complex decision that depends on multiple aspects, including defining the role, complying with minimum wage laws, researching market pay rates, and considering your budget.

In this article, we’ll explore each of these factors, provide a step-by-step guide to help you perform the calculations, and go through some of the most common mistakes business owners make.

Factors That Determine How Much You Should Pay Employees

Before you begin payroll calculations, you need to take into account multiple distinct factors; these represent the variables that influence pay rates and overall employee compensation.

Some of the biggest ones include:

• Industry standards. Different sectors can have vastly different pay structures. Employee pay rates can vary significantly based on aspects like skill requirements, profitability, market conditions, and so on. For instance, the roles in the tech industry usually come with bigger wages than those in retail positions.
• Role and seniority. The employee’s specific duties and responsibilities are some of the primary drivers behind their pay. Senior professionals with years of experience, sought-after technical skills, certifications, and other qualifications that are difficult to obtain often have much higher salaries than entry-level employees.
• Location. Geography is another important factor that directly influences the cost of labor. A professional working in a metropolis like San Francisco or New York City typically requires a much higher salary to maintain their standard of living compared to a peer from a smaller city in the Midwest.
• Supply and demand. Most industries are subject to the most basic economic forces. If there’s a high demand for a specific type of professional while there’s a shortage of such workers, employees will have to pay a higher amount to attract talent. On the other hand, when the demand for talent is low, employers have more leverage to negotiate.
• Company features. The company’s size, stage, budget, and strategy all influence how much it can pay its employees. For example, it’s common for startups to offer lower pay than established professional entities, while providing strong equity. Well-funded employers, meanwhile, are often willing to spend more to find top talent and build teams quickly.

How Much Should You Pay Your Employees: 8-Step Guide

To determine how much you should pay your employees, you need to have a systematic approach and consider every important factor. Here is a step-by-step guide that will help you create a compensation strategy that is competitive, legally compliant, and financially viable:

Step 1: Define the Role and Responsibilities

Before you can assign a value to the job position, you need to define the role and responsibilities. It’s recommended to write a detailed job description that encompasses everything from the required duties and qualifications to the needed skill and experience level.

Ask yourself questions such as whether you’re looking for a junior associate who requires training or a senior professional who can lead a team. Is the role going to be full-time or part-time? Is the employee going to be non-exempt or exempt (eligible or ineligible for overtime pay)?

Making these specifications is important for your future operations, as well. For example, hiring a manager on a salary exempt from overtime generally mandates that they have hiring and firing power. Labeling a position “Senior” and then hiring a less experienced candidate can lead to overpaying or worker misclassification.

Step 2: Check Minimum Wage Laws

Minimum wage laws set the limit under which you can’t go when determining employee wage rates. The exception applies to tipped workers for whom the minimum wage is much lower than for other workers. The current federal minimum wage, as governed by the FLSA, is $7.25 per hour for regular workers and $2.13 for tipped workers.

However, the U.S. has a tiered system when it comes to minimum wage requirements, where employers must comply with not just federal, but state and local laws, as well. In many states, the minimum wage is higher than the federal one, and employers are mandated to provide it to their employees.

For example, the minimum wage in Massachusetts is $15.00 per hour, as of 2026, and $6.75 for tipped employees. The rates can be even higher on a local level. Minimum wage in San Francisco, for instance, is $19.18 and set to increase to $19.61 on July 1, 2026.

Step 3: Research Market Pay Rates

Pay rates in many markets far exceed the legal floor. Companies that want to hire quality talent must offer compensation that is competitive in their field while still being sustainable for their business.

To figure out market pay rates, it’s important to use multiple reputable sources instead of relying on anecdotal evidence. Here are some of the sources to consider:

• U.S. Bureau of Labor Statistics. BLS is the government website that offers comprehensive data and all kinds of statistics for free. It has handy tools and charts, publications, economic releases, average pay by job, pay measure comparisons, and more.
• Career communities and salary aggregators. Websites like Glassdoor, Payscale, and Salary.com can give you solid estimates as to the conditions in your sphere and area. Keep in mind that the information is mostly self-reported, so the numbers can be inflated.
• Industry reports. Various professional associations periodically publish surveys and salary reports that can be highly specific and give you an in-depth insight into the conditions specific to your field.

Step 4: Consider Your Budget

While market research gives you an idea of how much you could pay, your budget represents a critical constraint that tells you how much you can pay.

A common rule is to allocate between 15–30% of gross revenue to payroll expenses. This number can go up to 50% if the business remains profitable. The percentage also varies depending on the industry. For example, service businesses often have higher payroll percentages than product-based ones.

It’s important to note that this encompasses all expenses, including payroll taxes and benefits. That’s why you should thoroughly analyze your cash flow. Examine the peaks and valleys to see whether you can sustain the salary during slow periods. Lowering salaries during less profitable quarters can negatively impact workforce morale and lead to retention issues.

Step 5: Decide on Hourly vs. Salary Pay

Deciding on salary vs. hourly pay requires legal consideration in addition to a financial one. Under the FLSA, employees can be classified into two distinct categories:

• Hourly workers (non-exempt). These employees are eligible for overtime pay. For every hour that they work over 40 in a week, they must be paid at a rate that is at least 1.5 times their regular rate.
• Salaried workers (exempt). Salaried employees are paid at a fixed rate, regardless of the hours worked. They are not legally owed overtime pay, but must pass the FLSA duties test and a salary threshold.

Here’s a table that outlines the key differences between hourly and salaried workers:

For instance, you can hire a marketing coordinator for a flat salary of $50,000 a year. However, if they don’t have executive power in the company, they may fail the duties test. This means you’d have to give them an hourly wage ($50,000 per year translates to about $24 per hour), at which point they also become eligible for overtime pay.

Step 6: Account for Benefits and Perks

The total amount that you have to pay your employees includes more than just base pay. Benefits and perks typically add 30–40% to the cost of base pay, and they fall into two categories:

• Mandatory costs. Employers are legally required to pay their share of Social Security and Medicare taxes (FICA tax), federal unemployment tax (FUTA tax), state unemployment tax (SUTA tax), and workers’ compensation insurance.
• Voluntary benefits. At their discretion, employers can choose to contribute to their employees’ health insurance, perform 401(k) matches, or provide paid time off (PTO). Many of these benefits are expected by top talent.

For example, if your employee’s base pay is $50,000 per year, mandatory taxes could be another $4,000, and health insurance could add $8,000, making the total cost around $62,000.

Step 7: Determine Employee vs. Independent Contractor Pay

Making a proper distinction between an independent contractor and an employee is essential to ensure legal compliance. 1099 contractor pay is typically lower than W-2 employee pay (as contractors are responsible for their own self-employment taxes and benefits), but it’s critical to avoid misclassification.

In case of uncertainty, the Department of Labor (DOL) may conduct an “economic reality” test to verify the relationship between an employer and its worker. If an employer has full control over the worker’s efforts (how, when, where they work), provides tools and locations, and is their only “client,” they are in an employer-employee relationship.

You can’t classify an employee as a contractor to save money, as that is illegal. Moreover, actual contractors will typically have higher rates than employees (usually between 30% and 50% higher) to cover the costs of self-employment.

Step 8: Create a Gross Pay Range

When you combine all the factors outlined above, you’ll be able to create a gross pay (not net pay) range. The lower value should still be in line with competitive pay rates to help you attract talent. Having a range gives you room to negotiate when hiring talent. You can take their skills and experience into account and come up with a figure that suits both parties.

Example

Let’s put these steps into practice on the example of a tech company in Austin, Texas, looking for a customer service manager:

1. Role: Mid-level, non-exempt employee.

2. Legal wage minimum: Texas adopts the federal minimum wage rate of $7.25 per hour.

3. Market conditions: Research shows customer service managers earn between $51,000 and $135,000.

4. Budget: Your budget for the base pay could be $75,000.

5. Pay structure: Hourly pay.

6. Benefits: Allocating ~$10,000 for benefits brings your cost up to $85,000.

7. Gross pay range: Your offer can be between $55,000 and $72,000, leaving room for a raise in the future.

5 Mistakes to Avoid When Determining How Much to Pay Employees

Before we wrap up this comprehensive guide on how to set employee wages, let’s take a look at five of the biggest and most common mistakes that you need to avoid:

1. Neglecting salary compression. Salary compression occurs when, due to the increase in market rates, new hires get paid the same or more than existing workers. This can lead to reduced satisfaction and even resentment in the employees who have been with the company for a while and haven’t had their pay reviewed and adjusted.

2. Not adjusting for inflation. The cost of living typically increases each year, and the salary should keep up with it. Failing to account for inflation when reviewing your small business payroll means employees are effectively getting a pay cut. This can result in reduced worker output, “quiet quitting,” and resignations.

3. Misclassifying workers to save money. Labeling a worker as an independent contractor means you don’t have to pay taxes on their salary or give them company-sponsored benefits. However, if they don’t meet legal criteria to be classified as contractors, you can get fined with back taxes, penalties, legal fees, and more.

4. Overlooking pay equity. The Pay Equity Act of 1963 mandates equal pay for employees who have substantially equal jobs. They don’t even have to have the same position within the company. If two employees have similar jobs but different pay, there has to be a documented reason for it (e.g., the quantity of production or seniority).

5. Focusing only on base pay. As we’ve already mentioned, perks and benefits can add 30–40% to the base pay. Some employees are also willing to take lower base pay if the benefits package is good. This makes perks and benefits a critical part of the calculations and a great financial tool for attracting talent.

Manage Your Pay with Paystub.org

Once you figure out how much you should pay your employees, you need a simple and efficient way to manage and document these payments and avoid payroll errors. At Paystub.org, we built professional and intuitive software that can help you streamline payroll processing, enhance record-keeping, and ensure legal compliance.

We offer the following tools that are perfect for small businesses:

• Pay stub generator. Effortlessly generate detailed and compliant pay stubs for your employees.
• Form W-2 generator. Create year-end tax forms for your workforce with ease.
• Form 1099 generator. Document payments made to independent contractors.

Final Thoughts

When determining how much you should pay your employees, you need to consider several factors simultaneously. Moreover, the process requires balancing current market trends (to stay competitive) with your business’s profitability (to ensure you can afford to pay your employees).

Don’t forget that paying employees legally also requires keeping various laws and regulations in mind (e.g., regarding equal pay and overtime). Finally, compensation is not a “set and forget” type of task. You must periodically review the pay to ensure it stays competitive and aligned with the latest legal and market changes.

How Much Should I Pay My Employees? FAQs

#1. How often should I review pay?

As a general rule, you should review employee pay once a year. This gives you enough time to gather information about the inflation, market conditions, and employee performance, all of which can influence your decision. Keep in mind that some fast-growing companies can review pay even twice a year.

#2. What is a competitive wage?

Competitive wage is the amount that meets or exceeds market benchmarks for that role. In general, the rate should be above the 50th percentile of the market rate for that position and location. Paying below often results in high turnover rates and difficulties finding talent.

#3. Do I have to provide pay stubs?

You have to provide pay stubs in states that mandate it. While federal law doesn’t require employers to provide pay stubs to their employees, most state laws do. Some states require employers to give employees access to digital pay stubs, while others require them to print and issue physical copies.

#4. Can I pay different rates for the same role?

Yes, you can pay different rates for the same role, as long as other factors are used as differentiators. This can include the person’s seniority, the quality of their work, their level of education, or specialized training, etc.