What is Retro Pay? How to Calculate and Distribute It

Payroll mistakes are inevitable and occur every now and then. When errors in preparing employee earnings take place, certain countermeasures, such as retro pay, may be needed to rectify the discrepancies.

There are factors to consider if you need to make retroactive payments to your employees.

In this article, we will define the meaning of retro adjustment, as well as discuss when you need to disburse the said type of payment to your employees and how to calculate it.

Key Takeaways

• Retro pay is supplemental compensation given to employees whenever there are discrepancies or errors in calculating their pay in previous pay periods.
• Retroactive pay typically arises when bonuses, commissions, pay increases, and overtime pay are not reflected on an employee’s paycheck.
• Calculating retro pay for hourly employees and salaried employees differs. Exempt employees are also not entitled to overtime or retroactive adjustments.
• All retroactive compensations are subject to regular taxation.

What is Retro Pay?

Retro pay, or retroactive pay, is a type of supplemental compensation given to employees on top of their regular salaries or wages. It is usually done to adjust or amend discrepancies in an employee’s pay from the last payroll.

Examples of discrepancies include paying employees inadequately or failing to include bonuses or increases in their salary in their latest pay stub. These types of errors are often caused by misclassifying employees or using an ineffective time-tracking system.

Employers must ensure they compensate their workers accordingly and provide speedy solutions to fix any mistakes in calculating employee earnings. Otherwise, employees may dispute the errors in their salaries.

When is There a Need for Retro Pay?

The need for a retro pay adjustment typically arises when employees receive insufficient pay, as exhibited in the following examples:

• Bonuses and commissions. Bonuses and commissions are rewards and extra payments added to an employee’s base earnings in exchange for reaching key performance indicators or target sales.
• Changing shifts. Inefficient tracking of employees’ work hours can leave a ripple effect of miscalculated hourly rates. This is common when an employee transitions to a different shift within the same pay period and the payroll officer fails to include all work hours rendered by the employee for both shifts.
• Overtime pay. Another instance of miscalculated pay involves not including the overtime hours completed by employees in calculating their salary. As long as an employee is nonexempt, they are entitled to receive compensation for additional work hours provided beyond their regular schedule.
• Promotions or lateral transfers. Promotions and lateral transfers within the company entail pay raises that may not reflect on employee’s pay stubs right away. By the next payroll, salary increases must already be included in the employee’s pay, including the adjustments for the previous payments where their pay raise was not added to their compensation.

How to Calculate Retro Pay

If you want to learn how to calculate retro pay, the first consideration is whether employees are paid hourly or at a fixed rate.

To help you understand better how retro pay works, below are examples of determining retro pay deductions for salaried and hourly employees:

#1. Retro Pay for Salaried Employees

Let’s say an employee earning an annual salary of $65,000 (or $5417 per month) was awarded a pay raise worth 5% of their initial annual rate.

That means the employee now earns an additional $3,250.

To calculate the retro pay, first take note of the employee’s initial and latest salary.

Based on the example above, the employee’s original rate is $65,000. Their new salary, which includes their increase, is now $68,250.

Next, check the date when the new or current salary took effect.

Count the number of pay periods when the employee receives compensation based on the company’s payroll cycle. If the employee is paid monthly, that means they receive their salary for 12 pay periods in a year.

Following their pay raise, the employee should be receiving $5,687.50 in gross wages.

Divide the employee’s previous salary by 12, or the number of pay periods when they receive compensation from their employer.

Employee’s previous salary: $65,000

Number of pay periods: 12

$65,000 / 12 = $5,416.67

Divide the employee’s current salary by the number of pay periods, which is 12.

Employee’s current salary: $68,250

Number of pay periods: 12

$68,250 / 12 = $5,687.50

Deduct the previous monthly salary from the employee’s current rate.

Previous monthly salary: $5,416.67

Current monthly salary after increase: $5,687.50

$5,687.50 − $5,416.67 = $270.83

If the employee’s paycheck did not reflect their new rate for three consecutive pay rolls, multiply the difference, $270.83, by 3.

$270.83 X 3 = $812.49

You owe your employee retro pay worth $812.49.

#2. Retro Pay for Hourly Employees

Figuring out retro pay for hourly employees based on the given example requires recounting their retro hours, meaning you need to determine the number of overtime hours that were not included when calculating their wages.

An employee is paid $20 per hour and receives their wages biweekly. During the first week of the month, they completed a 20-hour work week. The following week, they worked an extra 7 hours.

Their latest paycheck only reflected wages based on regular work hours.

First, calculate the amount paid to the employee in gross wages for two weeks, disregarding the overtime hours.

Hourly rate: $20

Hours worked for two weeks, excluding overtime hours: 40 hours

$20 X 40 = 800

Next, determine the amount to be paid to the employee for their overtime work.

All you have to do is multiply their hourly rate by 1.5. Multiply the result by the number of extra hours they completed.

Hourly rate: $20

Extra hours: 7

$20 X 1.5 = 30

30 X 7 = $210

In this example, the resulting overtime value is the retroactive amount you owe to your employee.

It is important to note that only nonexempt employees are entitled to retro adjustment, meaning if an employee is exempt from overtime pay requirements and minimum wages, then you do not owe them retro pay for extra work hours.

Retro Pay and Tax Withholdings

Much speculation is raised on whether retro pay is taxed differently from regular wages. In truth, retro pay is subject to tax withholdings in the same manner that an employee’s regular earnings are.

Put simply, all federal, state, and FICA taxes must be applied to the employee’s retroactive compensation. Consequently, you must also continue to pay your share of the taxes as the employer.

When in doubt, it is best to seek the assistance of your state or local government to determine the correct amount to withhold for state and local taxes. Meanwhile, using the aggregate method is most suitable for calculating taxes for FICA and federal income taxes.

How to Distribute Retro Pay

When it comes to distributing or issuing retro pay to your employees, you can attach it as aseparate paycheck from their next regular wage statement. Alternatively, you can include the retroactive adjustment as miscellaneous earnings in their pay stub.

You must also be ready to discuss the salary adjustments with your employee in case they have questions about their retro pay. In fact, you might also need a calculator to show how the adjustments were determined and added to their regular wages.

Finally, don’t forget to explain to your employees that retroactive payments are still subject to regular tax withholding.

The Difference Between Retro Pay and Back Pay

The following are the key differences between retro pay vs back pay:

• Back pay is an example of retro pay. It refers to the full compensation that employers owe to their employees if the latter did not receive any payment for an entire pay period.
• Retro payments can either be overtime pay, bonus, or commission that was not reflected in an employee’s previous paycheck.
• Back pay is often supported by legal action sought by employees against employers who notoriously underpay their staff.
• Retroactive pay can be calculated and amended easily by a company’s accounting and payroll staff. The supplemental compensation can also be disbursed on the following pay day, provided that all necessary adjustments are made.

Can Retro Pay be Ruled in Court?

Yes, retro pay can be ruled on in court. When retroactive payment is backed by a court order, it is usually the result of severe malpractice in the workplace.

Employers are mandated by the court to compensate retro pay to their employees if proven guilty of the following workplace violations:

• Compensating employees less than the minimum wage recommended by the federal or state government.
• Notoriously disregarding overtime hours worked by nonexempt employees.
• Consistently missing the company’s pay schedules, thereby increasing the possibility of accumulating miscalculations on employees’ previous pay stubs.
• Failing to pay employees based on the regular rate or pay declared in their employment contract.
• Discriminating against employees based on their gender, race, disability, or age.

Final Thoughts

Now that you know the meaning and definition of retro pay, you must also memorize the different methods to calculate retroactive adjustments for hourly and salaried employees.

Technically, incurring retro pay adds to your list of payroll liabilities.

While payroll mistakes are unavoidable at times, that does not leave you free of your responsibilities to amend the errors on your employees’ income. After all, every employee deserves proper compensation and fair treatment at work.