What Is a Retention Bonus and How It Works (+ Pros and Cons)

A retention bonus is a one-time payment that employers give to valuable employees as a financial incentive. It’s primarily used to ensure the talent doesn’t leave the company during vital periods, such as when there are significant projects that need to be finished or when a company goes through the process of restructuring.

In this article, we’ll go through the meaning behind the retention bonus and explain it in depth. We’ll see how it works, when employers should offer it, and how the bonus should be structured. Finally, we’ll discuss the tax implications associated with these payments, as well as their pros and cons.

What Is a Retention Bonus?

A retention bonus is a financial incentive offered to key employees to convince them to stay with the company for a specific period. It’s a one-time payment that employers often use during times of high pressure or risk.

Retention bonuses can be given as:

• Lump sum paid to the employee after they have completed a required service period (e.g., $10,000 paid after 12 months).
• Recurring payments, where employees receive their retention bonus in installments (e.g., with monthly pay, every quarter, or upon hitting specified milestones).

It’s important to distinguish between an employee retention bonus and signing or performance bonuses. While these are all financial incentives, the circumstances in which they are provided are different:

• Signing bonuses are paid upfront, enticing a new hire to join the company.
• Performance bonuses are paid based on the results that have been achieved.
• Retention bonuses are given based on an employee’s time and loyalty; performance clauses may be added, but they aren’t mandatory.

How a Retention Bonus Works

A retention bonus works as a contract, not a gift. It’s often referred to as a “stay bonus,” and it’s a formal arrangement between an employer and an employee.

Three main aspects govern the effectiveness and legality of a retention bonus agreement:

1. Eligibility

2. Employment period requirement

3. Payment timing

Eligibility is determined at an employer’s discretion. Not every employee gets a retention bonus; they are typically reserved for:

• High-performers with exceptional skill and experience, whose leaving would cause significant damage to the company’s productivity
• Key executives with lots of responsibilities who are in charge of steering the organization during high-pressure periods
• Staff with institutional knowledge, such as proficiency in legacy or proprietary systems and processes that nobody outside the organization knows

The employment period requirement—retention period—is the main idea behind a retention bonus. It represents a specific timeframe (e.g., 6 or 12 months, though it can be longer for complex mergers, for instance), during which an employee is required to stay with the company. If an employee leaves before that voluntarily, they don’t receive the bonus.

Payment timing defines when and how the employee will receive their retention bonus. A common route (and the safest one for the employer) is the “pay-on-completion” model, where the money is given after the final date passes. However, employees may receive portions of the bonus (installments or even full amounts) in advance.

In cases of advance payments, employers often include clawback clauses in written agreements. They make it so that the employees must pay the money back in case they leave before a determined date.

Retention Bonus Calculation Example

Let’s put this theory into practice and take a look at a simple example of the retention bonus calculation:

• Employee: Senior project manager earning $120,000 per year.
• Situation: 12-month critical software migration for which the employee is essential.
• Strategy: Offering a retention bonus in the amount of 15% of their base salary.
• Calculation: $120,000 * 0.15 = $18,000
• Payment structure: $9,000 paid after 6 months, and the remaining $9,000 paid after the project completion in 12 months.

When Should Employers Offer a Retention Bonus?

Let’s see what some of the most common situations are in which employers should offer a retention bonus.

#1. High Turnover Roles

Industries like healthcare, cybersecurity, retail, and customer support have high turnover rates. Good talent is scarce, finding it is difficult, and it’s not uncommon for competition to poach valuable employees. Moreover, turnover can cripple operations and result in significant setbacks, making retention bonuses a critical financial tool.

Employers use them to stabilize their staff when they can’t be retained with salary alone, reduce costs associated with frequent recruiting, and maintain continuity in their production. Retention bonuses buy organizations time to fix underlying issues without damaging current operations.

#2. Mergers and Acquisitions (M&A)

Mergers and acquisitions often trigger retention bonuses as they lead to employee disengagement. When one company buys another, employees start fearing restructuring and layoffs, issues with culture clashing, or changes in established roles and dynamics. This often makes them look for other opportunities and move when companies need stability.

That’s why buying companies usually identify key employees (e.g., top management or tech leads), and offer them bonuses to stay through integration phases (typically for 6, 12, or 24 months).

#3. Critical Projects

When a company is close to launching a significant project, it becomes imperative to maintain the essential employees who work on it. Losing a project manager or a lead engineer could lead to significant delays that would have a catastrophic impact on the company’s operations and finances.

In these cases, it’s common to tie a retention bonus to a project completion date rather than a generic timeframe or a calendar date.

#4. Seasonal Workforce

Seasonal workers (e.g., e-commerce employees during holidays or tax professionals during filing seasons) are susceptible to burnout and mid-season attrition. Retention bonuses structured to be paid after the season ends help reduce stress in these employees and motivate them to work at optimal efficiency.

How to Structure a Retention Bonus

Structuring a retention bonus requires conducting a cost-benefit analysis and a risk assessment. There is no one-size-fits-all solution, and bonuses are determined on a case-by-case basis.

First, start with the objective and the reason why a retention bonus is offered. For instance, this can be due to a specific project going on or as a way to reduce turnover.

Then, determine the amount. In general, retention bonuses are calculated in one of two ways:

• Percentage amount. This is common for salaried employees. Bonuses usually range between 10% and 25% of the employee’s annual salary.
• Fixed amount. Flat dollar amounts are typically given to hourly employees or when there’s a whole team involved. They simplify communication and calculations.

Finally, draft the agreement. Every retention bonus needs to be documented with a written agreement signed by both parties. This ensures clear communication between everyone involved and makes it easy to resolve any potential disputes.

A typical agreement should cllearly state:

• The gross amount in dollars that will be given as a retention bonus.
• The retention period with specified start and end dates.
• Payment terms. Similar to invoice payment terms, they describe whether an employee will be given a lump sum or paid in installments.
• Termination clauses that describe what happens if an employee is fired for cause (they usually get nothing) or laid off without cause (they usually get a pro-rated amount).
• Clawback clauses are included if an employee is being paid upfront to ensure they repay the bonus if they leave the company early.

Are Retention Bonuses Taxable?

Yes, retention bonuses are taxable because the IRS recognizes them as supplemental pay. However, this also means they aren’t taxable in the same way as an employee’s regular wage, which can lead to confusion.

When it comes to federal taxes, employers can choose between one of two tax withholding methods for retention bonuses:

1. The percentage method. This is a more common method, where the employer withholds a flat 22% of the retention bonus. If the bonus is over $1 million, it will be taxed at 37% instead.

2. The aggregate method. This method involves adding the bonus to the employee’s salary into a single payment and withholding tax from the entire sum. The withholding amount is based on the employee’s Form W-4.

Regardless of the method chosen by the employer, the retention bonus is also subject to FICA taxes. This encompasses 6.2% withholding for Social Security (up to the limit of $184,500 in 2026) and 1.45% withholding for Medicare tax (with no limit).

Also, some states may have specific laws regarding supplemental wages. That’s why it’s important to do research and check with the local tax administration whether there are state and local retention bonus taxes that you need to consider.

Finally, the retention bonus must be documented and reported accurately. It needs to be included in an employee’s pay stub, typically as a separate item in the income section. Additionally, employers need to report these payments on employees’ Forms W-2.

Pros and Cons of Offering Retention Bonuses

There are many good reasons for offering retention bonuses, but the process comes with some drawbacks, as well. Let’s see what the biggest pros and cons are.

Benefits for Employers

Let’s start with the biggest benefits that employers get when leveraging retention bonuses:

• Stability during uncertainty. The main reason behind a retention bonus is to ensure the key employees stay with the company in periods of crises or mergers. This allows companies to focus on output rather than recruitment.
• Cost effectiveness. Retaining an existing employee who has the necessary skills and knowledge is usually much cheaper than hiring someone new. There are costs associated with recruitment and onboarding, but also the loss of productivity while hiring a replacement.
• Morale boost. An employee who receives a retention bonus will see it as a sign of appreciation. The bonus represents tangible acknowledgement of their value to the company, which can enhance their productivity.
• Bought time. Companies can use retention bonuses as quick fixes when working on long-term issues. With bonuses, they can buy enough time not to run into bigger issues before solving them.

Potential Drawbacks

Now, let’s take a look at some of the potential drawbacks and risks of offering retention bonuses:

• Resentment among peers. Employees who don’t receive retention bonuses may become jealous of those who do. This can lead to complaints and a toxic culture in the organization.
• Bare minimum productivity. Unhappy employees who receive retention bonuses may not change the way they feel or work, but stay around purely because of the bonus. Their productivity can stay low, and they can even bring the morale of other employees down.
• Not a complete fix. Retention bonuses typically don’t solve the root causes of issues on their own. As such, if a necessary change doesn’t come on an organizational level, the problem will stay even after the employee receives their bonus and leaves.

3 Common Mistakes to Avoid When Giving a Retention Bonus

Before we wrap up, let’s go through the three biggest mistakes that you can make when giving a retention bonus:

1. Unclear terms and conditions. Being vague about the terms or using verbal agreement to give your employee a retention bonus can lead to complications and disputes. If you employ this tool often, you should set a clear retention bonus policy and make sure that there’s always a detailed written agreement signed by everyone involved.

2. Poor timing. A retention bonus shouldn’t be used as a counteroffer after an employee has already handed in their resignation. Instead, the offer should come proactively. Try to identify the risks and develop a forward-looking strategy. This allows you to act before the worker has already made up their mind, maximizing the chances of success.

3. Using bonuses inconsistently. Offering different bonuses to professionals in similar roles and with similar responsibilities can lead to multiple issues. On the one hand, you open doors to possible discrimination claims and lots of legal trouble. On the other hand, employees can get into conflict with each other and with you.

Issue and Document Retention Bonuses with Paystub.org

At Paystub.org, we offer several handy software generators that you can use to create the necessary documentation for processing and recording retention bonuses. You can use our tools with no prior knowledge or training, and they allow you to create professional and legally compliant documentation with ease.

Here are the key tools that you can use when giving retention bonuses:

• Pay stub generator allows you to add a retention bonus as a separate item with a click of a button.
• Form W-2 generator helps you document these payments for your employees in their year-end tax forms.

Final Thoughts

A retention bonus is a powerful financial tool that offers short-term fixes to various operational challenges that businesses face. When used strategically, it can ensure your organization’s stability, giving you time to complete your projects, overcome turbulent times, or fix underlying issues.

It is best used in combination with robust long-term strategies, such as reducing turnover, improving the company’s culture, or completing a successful merger.

Remember to communicate the terms clearly and put everything in writing. Following that, you want to ensure accuracy from a legal standpoint, which means you must practice proper retention bonus payroll processing and recordkeeping.

Retention Bonus FAQs

#1. Can small businesses offer retention bonuses?

Yes, small businesses can offer retention bonuses. Additionally, retention bonuses are often much more valuable to these businesses since they have small teams and every member is critical. The terms and the structure stay the same regardless of the business size.

#2. Should retention bonuses be in writing?

Yes, retention bonuses should be in writing. While verbal agreements are also valid, they make it much more difficult to keep both parties accountable and may even lead to misunderstandings. A formal, written agreement protects both parties involved and helps resolve any disputes much more easily.

#3. Can contractors receive retention bonuses?

No, contractors generally don’t receive retention bonuses. These types of bonuses are reserved for W-2 employees, and giving them to contractors may result in classification issues, as it could blur the lines of the relationship between the payer and the payee. Bonuses paid to contractors are simply extra income.

#4. Do retention bonuses appear on pay stubs?

Yes, retention bonuses appear on pay stubs. Since these bonuses are considered supplemental wages and, thus, taxable income, they must be processed and recorded accordingly. This usually means listing the bonus as a separate item in the income section, described as “Bonus,” “Supplemental Pay,” or “Retention Incentive.”