How to Create a Compensation Plan That Works + Template

Knowing how to create a compensation plan is a critical skill since it allows you to compensate your staff appropriately, including determining their salaries or wages, bonuses, benefits, and other incentives. A well-designed plan is fair, functional, and compliant, and ensures that you’re competitive in the labor market.

In this article, we’ll learn precisely what a compensation plan is, why it’s different from a salary, and what types there are. Then, we’ll go through the key components that every plan should have before giving you a detailed guide on how to create one. We’ll also give you a template that you can use and go through some of the mistakes that you need to avoid.

What Is a Compensation Plan?

A compensation plan is a complete payment package designed to attract and retain talent. It involves developing a comprehensive framework to ensure internal equity, compliance with tax and labor laws, and competitiveness in the labor market.

Companies develop formal and detailed plans and strategies to determine how their employees are being paid. This allows them to predict their labor costs and avoid making arbitrary decisions that can lead to reduced profits or discrimination claims.

Salary vs. Compensation

The difference between salary and compensation is that the former represents only one component of the compensation package: fixed and regular pay employees receive for their work (e.g., $70,000 per year).

On the other hand, compensation is a broad term that encompasses all financial and non-financial rewards. This includes fixed salary, but also variable pay (e.g., commissions and bonuses), indirect benefits (e.g., employer-sponsored health insurance or 401(k) matching), and non-monetary perks (e.g., stipends for professional development and paid time off).

Who Needs a Compensation Plan?

Every business that employs staff needs a compensation plan. This includes everything from small startups with a handful of employees to enterprise-level organizations.

Some small businesses make the mistake of giving arbitrary pay rates based on little to no research (e.g., based solely on immediate needs). This can quickly lead to payroll budgeting issues or wage disparities. That’s why every company needs a well-structured and legally compliant compensation plan.

Types of Compensation Structures Businesses Use

There are several types of compensation structures, and many businesses use more than one for different workers or teams they employ. Here are the most common ones:

Fixed Salary

A fixed salary represents a set amount that an employee earns annually. It is typically paid in installments (e.g., a biweekly payroll or a monthly payroll).

This type of compensation is common for exempt employees, who are not eligible for overtime pay. It’s a straightforward structure that simplifies administrative processes while giving employees stability. They can look forward to the same paycheck regardless of the hours worked.

Hourly Wage

An hourly wage is a compensation structure where an employee is paid for every hour they work. This is a standard for non-exempt employees, and their pay is calculated when multiplying the number of hours worked by their hourly rate.

Since non-exempt employees are eligible for overtime, they must also be paid at an increased rate (at least 1.5 times their regular rate) for every hour over 40 worked in a week.

Hourly wage offers flexibility to employers but requires meticulous time tracking and rate calculations.

Commission-Based

A commission-based compensation structure ties an employee’s earnings to their performance. This is common in sales fields, where an employee earns their salary by making sales or generating revenue for the company and securing a percentage of it for themselves.

This compensation structure encourages efficiency and productivity. However, employers must ensure that employees are paid the federal and state minimum wage, even if they don’t hit their targets.

Hybrid Model

Finally, a hybrid compensation model combines fixed and variable pay. This gives employees the stability of a salary with an incentive to earn based on their performance.

One example of a compensation structure like this includes the 70/30 model, where 70% of employees’ earnings are fixed, and the remaining 30% is variable and based on their efforts. This model is common in sales and executive roles.

Key Components Every Compensation Plan Should Include

Every compensation plan needs to contain several key elements to ensure its proper design. These need to work together to create a comprehensive system that defines how rewards are determined, communicated, and distributed.

The components of a compensation plan can broadly be categorized into the following groups:

• Pay philosophy refers to the way your company approaches compensation and the way it positions itself in the market. You can:
  • Lead the market and offer above-average pay to attract top talent.
  • Meet the market and pay average rates to control the costs
  • Lag the market and pay below average while finding other ways to attract talent.

Your philosophy influences your overall hiring and compensation strategy, and it needs to align with your financial capabilities.

• Job levels and pay grades establish the organizational hierarchy within the company. Job levels are categorized in distinct groups (e.g., junior, mid-level, and senior), while pay grades establish salary ranges (minimum and maximum pay) for each level. Depending on the size of the company and its industry, there can also be job families (e.g., marketing, engineering).
• Variable pay and incentives add performance-based rewards and monetary incentives that you may offer outside fixed salaries. This encompasses project-completion and end-of-the-year bonuses, sales commissions, and profit-sharing distributions. Using variable pay as a financial incentive can boost employee productivity by aligning their goals with the company’s.
• Employee benefits and perks are indirect, non-monetary forms of compensation that can significantly impact staff hiring and retention. Optional benefits, like employer-sponsored health insurance (which becomes mandatory under the Affordable Care Act for companies with 50+ employees), 401(k) matching, and wellness and other stipends, are vital for talent acquisition.

How to Create a Proper Compensation Plan

To create a proper compensation plan, you need a systematic approach that requires analyzing the market and thoroughly understanding your financial situation and goals. Here are the steps to help you achieve that:

#1. Define Compensation Goals

Before diving into the numbers, you need to define what you want to achieve with your compensation plan.

For example, a fast-growing startup may need to hire quickly to ensure rapid scaling, in which case they’ll want to lead the market with high base pay. On the other hand, companies that want to improve retention rates may focus on long-term financial incentives and enticing benefits. Companies with budgetary constraints may focus on non-financial perks the most.

Your goals will dictate the entire process of payroll compensation planning. They will influence how aggressive or strategic you will be with pay ranges, what incentives you may offer, what the tactics will be regarding promotions and raises, and more.

#2. Create Job Families and Levels

To ensure pay equity and fairness within your organization, you need to categorize the roles based on the type of work and experience levels.

A job family refers to a group of positions that revolve around similar types of work, but may need different degrees of skill and experience. This is typically how different teams or departments are made (e.g., marketing team, HR team, engineering team).

Job levels are generally determined within each family and set based on the experience a person has, their impact on the company’s output, and the scope of their responsibilities (e.g., junior, mid-level, and senior positions).

Creating distinct job families and levels prevents employers from making arbitrary decisions regarding compensation. They ensure all employees are paid based on the same rules. Plus, it gives workers roadmaps they can use when planning their career progress and working toward promotions to higher job levels.

#3. Establish Pay Ranges

With job roles split into families and levels, you can assign them pay ranges based on market data. At this point, you should use established resources to ensure that your salaries meet industry standards. You can use specialized surveys, salary websites, BLS wage data, and other sources to get the required data.

For each pay range, you should have a minimum, midpoint (current market rate), and maximum rate. This gives you flexibility to negotiate with talent and meet their needs, while potentially leaving room for future promotions and raises. Keep in mind that your ranges must comply with FLSA regulations (e.g., above the minimum wage).

#4. Decide on Incentive Structures

Once you’ve set base pay, you should continue with variable pay and incentive structures as a means of motivating your workforce.

If you have sales positions, you should establish clear commission rates (e.g., percentages or tiered structures). For other roles, you can design annual or other types of bonuses and tie them to performance or company revenue goals.

Startups often use equity to reward employees while simultaneously making them more invested in the organization’s long-term success.

#5. Set Promotion and Raise Rules

A well-thought-out compensation plan design needs to account for the future. It needs to have transparent rules for when and how employees can get promoted and receive raises. The system can be set up to tie raises and promotions to performance reviews, employment milestones, skill development, or a combination of multiple factors.

Consistency and open communication will prevent biases from employers and managers while simultaneously helping employees grow within the company.

#6. Establish Payroll Processes

The last step involves establishing a precise and compliant payroll process. This involves determining your pay schedule (e.g., biweekly or monthly), ensuring compliance with wage and tax laws, and streamlining the process of creating pay stubs, Forms W-2, Forms 1099, and other payroll documentation.

Compensation Plan Template for Small Businesses

If you need a way to structure employee pay for your small business, and you don’t know where to start, you can use a compensation plan template that we created. It will give you a solid starting point and guide you through drafting your plan.

Here is the template:

• Pay philosophy.
  • Compensation goal: [e.g., meet the market by offering the average rate, then attract top talent with work-life balance perks]
• Job levels and pay ranges.
  • Level 1 (Entry): [e.g., 0–2 years of experience, $45,000–$55,000]
  • Level 2 (Mid): [e.g., 2–5 years of experience, $60,000–$80,000]
  • Level 3 (Senior): [e.g., 5+ years of experience, $85,000–$120,000]
• Variable pay and incentives.
  • Sales: [e.g., 70/30 structure; 70% base salary, 30% commissions tied to quotas]
  • Non-sales: [e.g., up to 5–10% end-of-the-year bonus based on role-specific KPIs]
• Employee benefits and perks.
  • Core: [e.g., 3% 401(k) match, 80% employer-sponsored health insurance]
  • PTO: [e.g., 8 paid federal holidays, 15 additional days per year]

Why a Compensation Plan Matters for Businesses

A compensation plan matters for a business from both the operational and legal standpoints, as it allows you to:

• Attract talent. Competitive plans with good pay rates, strong benefits packages, or a combination of both are usually required to recruit qualified professionals.
• Improve retention. When employees understand their pay, have incentives to excel in their roles, and see clear roadmaps for raises and promotions in the future, they are more likely to stay around for longer.
• Ensure compliance. Creating a detailed employee compensation plan allows you to double-check every aspect of it. This minimizes the risk of making a mistake and violating wage laws.
• Maintain internal fairness. Negotiating salaries with new hires without having set ranges can result in significant wage disparities and resentment among the staff. Standardized pay ranges ensure internal equity.
• Control your budget. Payroll expenses are often the biggest ones for businesses. Having a plan that aligns with your finances improves your stability while making your budgeting efforts predictable and scalable.

4 Critical Mistakes to Avoid When Creating a Compensation Plan

Here are some of the biggest mistakes employers make when creating compensation plans:

• Ignoring market data. Setting pay rates based on your instincts or outdated information can result in severe underpayment or overpayment. Instead, you need to use reputable and updated sources, and update your rates regularly (e.g., once per year).
• Lacking transparency. Not having clear policies and keeping compensation a secret leads to mistrust among employees. Moreover, it can violate emerging pay transparency laws (e.g., Senate Bill No. 642 in California).
• Not updating. A compensation plan is not a set-and-forget endeavor. You need to review it annually to account for inflation and ensure your salaries don’t lag behind the market.
• Being inconsistent with promotions. Arbitrary raises and promotions may lead to internal inequality. That’s why it’s important to standardize the criteria you use.

Execute Your Compensation Plan with Paystub.org

Accurate and professional documentation is essential to maintaining a compliant compensation plan. Paystub.org helps you save a ton of time and effort by allowing you to generate the following payroll documents with ease:

• Pay stubs
• Forms W-2
• Forms 1099

Final Thoughts

The bottom line is that if you run a business that employs others, you must know how to create a compensation plan. It will help you position yourself in the labor market, attract the right talent, compensate them appropriately, and ensure compliance with the law.

The good news is that creating a plan is not that difficult when you know its key components. Plus, we’ve provided you with a template and a compensation plan example to give you a starting point. Just make sure to regularly review the plan as your business grows, the market shifts, and labor laws change; this will help you mitigate the risks and ensure long-term success.

How to Create a Compensation Plan FAQs

#1. What is a 70/30 compensation plan?

A 70/30 compensation plan represents a common payment structure where 70% of the employee’s earnings are from a fixed, guaranteed salary, while the remaining 30% represents variable pay, which they earn through commissions and bonuses.

#2. What are the 4 types of compensation?

The 4 types of compensation are hourly, salary, commission, and bonuses. In HR management, four different types of compensation can also refer to base pay, variable pay, equity compensation (stock options or profit-sharing), and indirect benefits (PTO, 401(k) matching, health insurance).

#3. Do small businesses need compensation plans?

Yes, small businesses need compensation plans. This allows them to approach negotiation with data and no bias, to ensure pay equity between their employees, and to stay compliant with federal and state labor and tax laws.

#4. How often should compensation structures change?

Compensation structures should change annually to account for inflation and shifts in market trends. However, these should be minor changes that affect just parts of the structure. Major overhauls typically happen every two or three years, or when a company goes through a significant change in size or strategy.