Everything you need to know about the employee compensation. Compensation or Remuneration is a systematic approach to provide monetary value to employees in exchange for work performed by them is called as compensation or remuneration.

Compensation may achieve several purposes assisting in recruitment, job performance and job satisfaction.

Learn about:- 1. Definitions of Employee Compensation 2. Meaning and Concept of Employee Compensation 3. Objectives 4. Factors Influencing  5. Components 6. Planning 7. Steps for Determining Compensation 8. Importance  9. Principles 10. Types 11. Objectives 12. Mistakes in Compensation Design 13. Issues.


  1. Definition of Employee Compensation
  2. Meaning and Concept of Employee Compensation
  3. Objectives of Employee Compensation
  4. Factors Influencing Employee Compensation
  5. Components of Employee Compensation
  6. Planning for Employee Compensation
  7. Steps for Determining compensation
  8. Importance of Employee Compensation
  9. Principles of Employee Compensation
  10. Types of Employee Compensation
  11. Objectives of Effective Compensation System
  12. Mistakes in Employee Compensation Design
  13. Issues in Employee Compensation

Employee Compensation – Definitions: Suggested by R. Wayne Mondy, Gary Dessler, Terry Leap and Cascio 

Compensation or Remuneration is a systematic approach to provide monetary value to employees in exchange for work performed by them is called as compensation or remuneration. Compensation may achieve several purposes assisting in recruitment, job performance and job satisfaction.


In the case of Human Resource Management, compensation is referred to as money and other benefits that are received by an employee for providing services to his employer.

Money and benefits received may be in different forms — based compensation in money or monetary form and various benefits, these may be associated with employee’s service to the employer like provident fund, gratuity and insurance scheme and any other payment which the employee receives or benefits he enjoys in lieu of such payment.

R. Wayne Mondy defines compensation as, “Compensation is the total of all rewards provided to employees in return for their services. The overall purposes of granting compensation are to attract, retain and motivate employees.”


Gary Dessler opines, “Compensation means all forms of pay or rewards going to employees and arising from their employment.”

Terry Leap opines, “Compensation is a broad term pertaining to financial rewards received by persons through their employment relationship with an organisation.”

Cascio states, “Compensation includes direct cash payments indirect payments in the form of employee benefits and incentives to motivate employee to strive for higher levels of productivity.”

Employee Compensation – Meaning and Concept 

Compensation is one of the most important parts of an employment contract that brings in people from outside and makes them members of an organization. The pull effect of an organization’s com­pensation system, however, varies from industry to industry and from position to position within the industry.


Industries that are in a state of flux experiencing rapid change in technology of operation and fast change in business practices may find their employees very sensitive to compensation prac­tices of other organizations. In contrast industries that are relatively stable both in terms of the way business processes are conducted and in terms of the way organizations compete with each other, have employees who may not show much sensitivity to difference in compensation with employees working in other organizations.

Example- Employees working in IT and IT enabled service industries, and to some extent the banking industries show such behaviour of high concern and sensitivity to compen­sations rates of their employer. Similarly, young and fresh college graduate employees of companies show higher sensitivity to compensation practices of their employers than their senior managerial executives.

All in all it can be safely said that among the many policies and practices that influence a prospective employee’s choice of employer, compensation policies and practices rank well above many other areas of HR practices.

In conventional management practice, most organizations pay their employees according to certain historical rates which may have been set well in the past and are adjusted based on the changing cost of living due to inflationary pressure. Ideally an employee should be paid what his or her works and services are worth in the company. But this evaluation of actual worth of an employee service is fraught with a number of complexities.


Firstly, to know the actual service value an employee can rarely trade his/her services in the open market. Most employees’ services are traded in an internal market of the employer. Majority of the industrial organizations do business on a few selected number of goods and services which are produced from the joint efforts and services of many employees. There is very little revenue that a company earns which could justifiably be claimed as that due to efforts and labour of just one particular employee.

Secondly, unlike daily hired labour most organizations engage their employees over a long period. There is hardly any job which could be executed by a spot contract of hired labour. Most employees’ works and efforts are evaluated only over a period of time. And, within this long period there could be many changes in environmental factors that could affect the performance and output of those employees. And, so is the worth of their jobs.

Apart from these job-worth-related complexities, an employee compensation decisions are influ­enced by three other factors, viz. an employee requirements of income for living, an organization’s ability to pay, and its long-term strategic needs. An employee chooses to work in a company because it is a way to earn his/her living.

If this minimum sustenance re­quirements for an employee and his/her immediate family members are not met by the employer, then the employee’s biological renewal process could be in jeopardy and he/she will be in his/her own right to seek alternative means to protect his/her life. The result is that an employee whose sustenance is not guaranteed by an employer cannot be expected to show up for job the next day.


No wonder work place absenteeism is so high among lower level factory workers. In other words, an employer must ensure that the wage he/she is paying to an employee is sufficient to meet the basic biological needs of the employee and his/her family. This sustenance issue and consequent salary adjustment could become complicated when inflationary pressure in the economy is very high or when an employer moves his/her employees across different locations of widely varying cost of living.

Further, the very definition of basic needs is local environment driven and a moving target rather than a static universal law of nature! A basic need that was defined say in the 1950s could not be considered as valid in 2010. Similarly, a basic need for employees working in an agricultural farm could not be used as a valid package for someone working in a five star hotel or in a hazardous job of digging coal in underground mines.

The company’s ability to pay is another factor that may affect its compensation rates. Employees working in a company that is making good profit are found to earn more than employees doing similar jobs in other companies which are making less profit.

In good times, most employers tend to make higher payment to their employees because it ensures better relations between management and workers and creates a sense of ownership and pride among rank and file employees. Such above average compensation rate also makes these companies a preferred place of work to job seekers which may reduce their employee search cost substantially.


With fast-changing conditions of external environment of business, success requires long-term planning. Companies now prefer to make employment contract with long- term evaluation of worth of an employee rather than for his/her their current position and contri­bution. This means even if an employee’s actual worth of current contribution is not very high yet a company may prefer paying him/her more than his/her worth if it finds he/she is likely to be very useful in the near future.

In our country, with economic liberalization and relaxation of governmental control on managerial compensation, the compensation system of commercial organizations in gen­eral and their managerial compensation in particular have been going through rapid change. Many of them are choosing a compensation policy not just to meet their requirements of human resource services for today but to get those types of employees who may be able to provide them competitive advantage over a period of time.

Faced with shortage of qualified and experienced professionals, or­ganizations are experimenting with various types of new compensation policies to attract and retain the best employees as well as to reach out a larger of pool of talented fresh graduates of reputed management and technological institutes.

Employee Compensation – 10 Main Objectives

The main objectives of employee compensation are the following:


1. To attract well-qualified and competent personnel.

2. To motivate them for higher levels of performance by making arrangement of incentive payments.

3. To retain the present workforce by keeping their pay levels at the competitive levels.

4. To raise the morale of workforce.

5. To establish internal as well as external equity. Internal equity refers to payment of similar wages for similar work. External equity means payment of similar wages to similar jobs in comparable firms.

6. To maintain the labour and administrative costs in line with the ability of the organization to pay.


7. To comply with wage legislation.

8. To project a good image of company.

9. To satisfy employees and to reduce the incidents of grievances, absenteeism and quitting.

10. To reward the desired behaviour such as good performance, loyalty, dedication, etc.

Employee Compensation – Factors Influencing: External Factors and Internal Factors 

The significant factors affecting the employee compensation can be grouped together into two broad categories, external and internal factors.

1. External Factors:

(i) Demand and supply of labour in the labour market.


(ii) Labour union influence.

(iii) Government policies like Minimum Wages Act, 1948, the Equal Remuneration Act 1976, etc.

(iv) The prevailing rate of pay or comparable wage rates also influence the employee compensation.

(v) The present cost of living.

(vi) The state of the economy (boom, recession, depression, etc.).

(vii) Advancement of technology also influences the fixation of wage levels.

2. Internal Factors:


These factors include the following:

(i) Ability of the organization to pay.

(ii) The performance, experience and seniority of the employee.

(iii) Requirements of the job such as physical and mental abilities.

(iv) Job evaluation helps to establish satisfactory wage differentials.

(v) Organization’s strategy regarding employee compensation.

Employee Compensation – 4 Major Components: Basic Wages, Dearness Allowance, Bonus and Allowances 

The major components or constituents of employee compensation may include the following:

Component # 1. Basic Wage:


Basic wage is a stable wage paid over a period of time which could be on a monthly, weekly or daily basis. This wage is the normal rate for a given level of output. Thus, given a certain job, with all its attendant requirements of education, skills, training and expertise, it is the price to be paid to get it done.

It is usu­ally progressive over time, that is, it progresses more evenly over time if there is a running grade, other­wise it remains fixed with no changes. It is the basic wage that provides a stable base to the wage structure.

The fixation of basic wage is affected by statutory minimum wage, recommendations of Indian Labour Conference, patterns set by the awards of industrial tribunals, directives of the Pay Commissions, collective bargaining, wage settlements, periodic job evaluation and so on.

The basic wage may differ from job to job, depending on minimum educational and professional qualifications, training, skills, expertise, experience, skills and so on required by a particular job. It may also differ based on mental and physical requirements, responsibilities assigned, stress involved and so on.

Component # 2. Dearness Allowance:

Starting from the First World War, the system of payment of dearness allowance (hereafter DA) aims at neutralising the impact of price rise on the wages and salaries of employees. DA protects the wage earn­ers’ real income by neutralising the increased cost of living due to increase in prices.


However, some of the issues involved in this regard include whether the payment of DA should be automatic as soon as there is rise in the cost of living, and if it be so, what part of price should be compensated, that is, whether in full or partially, and whether the ‘capacity to pay’ of the industry is to be kept into consideration while deciding the payment of DA or increasing it.

There are various methods of DA payment. For example, DA may be linked to consumer price index (CPI) in a given region. As per this system, payment of DA is regulated on the basis of actual price movement in a particular region/sector or industry. The system may have two methods – (a) a specified rate of DA is fixed for every point rise in the CPI irrespective of the income group an employee belongs to and (b) the DA is based on income groups and cost of living brackets or slabs.

As per this system, the absolute amount of DA goes up with each higher income group. In it, DA does not change with every point in the cost of living index. Another example is that of flat rate system which provides a lump sum payment to the employees over a period of time to neutralise the impact of inflation.

Component # 3. Bonus:

Since some authors consider bonus as a deferred wage, it may be considered as a constituent of wage structure. In our country, payment of bonus is regulated as per the provisions of the Payment of Bonus Act, 1965.

Component # 4. Allowances:

Another component of the wage structure are various allowances which vary from organisation to organisation, industry to industry and region to region. Some of these allowances have become statutory.

Some of the popular allowances comprise house rent allowance, city compensatory allowance, leave travel concession, educational allowance, transport allowance, night duty allowance, hill allowance, shift allowance, book allowance, medical allowance, heat allowance, family allowance, uniform allowance, hazard allowance and so on.

Employee Compensation – 7 Steps Involved in Compensation Planning

The steps involved in employee compensation planning are as follows:

1. Understanding the company’s wage philosophy, guidelines, policy and so on.

2. Defining the boundaries and limits of employees in the organisation.

3. Knowing the expectations and want lists of the employees.

4. Estimating cost of various alternative programmes and comparing the same with the estimates of their effectiveness.

5. Cost-benefit analysis of financial and non-financial rewards.

6. Recognising a part of compensation cost as investment in employees which pays for long.

7. Based on all of these, working out a final pay package including financial and non-financial rewards.

However, compensation planning is not a simple exercise. It has to keep into consideration several things such as wage theories, job evaluation, job pricing, incentive plans, supplementary benefits and national wage policy.

Employee Compensation – Steps for Determining Compensation Process

Compensation is very important for the employee as his livelihood depends on it and it is his salary that determines his purchasing power. Compensation affects a person not just economically but also psychologically.

Thus, compensation should be determined very systematically by following the steps mentioned below:

Step # 1. Conduct Job Analysis:

It provides crucial information in designing pay systems. It describes the duties, responsibilities and other important job characteristics. Thus, it helps to determine and weigh the compensable factors (experience, skill, responsibility, effort, etc.).

Step # 2. Rate Worth of All Jobs by Job Evaluation:

The next step is to determine the worth of jobs with the help of job evaluation. This is to achieve internal equity. For each degree of a compensable factor, some points are assigned.

Step # 3. Create a Job Hierarchy:

In this stage, the points assigned to all compensable factors are aggregated. The listing of jobs is done in the order of their importance to the organization (starting from highest point to lowest point).

Step # 4. Conduct Market Survey:

After job hierarchy is created, the next step is to determine the prevailing wage rates. This is done to achieve external equity. Usually, a survey is conducted on a sample of selected key jobs and selected companies in the industry. Thus, the rates of key jobs in the labour market are determined.

Step # 5. Establish a Pay Policy:

The market survey may provide a range of wage and salary rates. The organization has to decide its pay policy keeping in view this range.

Step # 6. Pricing the Jobs:

In this step, the job evaluation worth is matched with labour market worth. Then appropriate pay levels for each job are established and different pay levels are grouped into pay grades.

Step # 7. Achieve Individual Equity:

Individual equity refers to fairness in pay decisions for employees holding the same job. At this stage, each employee is assigned a pay rate within the range established for his job. Generally, firms use previous experience, seniority and performance appraisal ratings to determine how much an employee should be paid within that job’s pay range.

Employee Compensation – Importance

A good compensation policy helps to motivate the employees to perform well. The remuneration that the workers receive for services rendered motivates them. A well designed structured compensation policy helps to secure the interest of the employees as well as to ensure effective organisation operation and attainment of overall organisational objectives.

The importance of compensation is discussed below:

1. It helps to determine fair, just and equitable pay for the workers. It tries to ensure that the paid fairly for their contributions to the organization.

2. A sound remuneration policy motivates the workers to work efficiently to achieve the specific standards.

3. Remuneration is the basis of happiness and satisfaction of the workforce. This helps in reducing labour turnover.

4. A sound, fair equitable remuneration policy helps to avoid conflict between the employer and the employees and establishes a peaceful relation between them.

5. It improves the morale and efficiency of the workers.

Obviously, to any employee, pay is the most important reason for working to earn livelihood. For some individuals, it may be the only reason. For most of us, it is the means by which we provide for our own and our family’s needs.

Compensation represents a large proportion of the expenditure. In manufacturing firms, it is seldom lower than 20 per cent; in service enterprises, it is often as high as 80 per cent (www(dot)eridlc(dot)com). More importantly, organizations try to accomplish many goals with compensation. These goals include attracting and retaining people, and motivating them to perform more effectively to achieve business goals. Compensation is also significant in the operation of the economy.

Salaries and wages are the largest contributing factors to the national income of many countries in the world and India is not an exception.

Employee Compensation – 12 Basic Principles

Compensation administration refers to the process of determining a cost-effective pay structure that will attract and retain competent employees, provide an incentive for them to work hard and ensure that pay levels will be perceived as fair.

Some basic principles of compensation administration are the following:

1. Different jobs require different kinds and levels of skills, knowledge and abilities and these vary in their value to the organization. So, efforts should be made to ensure that differences in pay are according to these variations.

2. Compensation administration should always be consistent with overall organizational plans.

3. Wage structure should be flexible enough to accommodate the changes in internal and external environment.

4. Compensation administration plans should be carefully designed and developed by considering the best interests of all the concerned parties such as management, trade unions, employees, society and government.

5. There should be equal pay for equal work.

6. Wage plans should be clearly defined and written to ensure stability and uniformity.

7. The level of wages should be in line with the prevailing rates in the labour market.

8. The employees should receive guaranteed minimum wages in order to maintain a reasonable standard of living.

9. There should not be any secrecy in the establishment of wage rates. Employees and trade unions should be well- informed regarding the procedure of setting wage rates.

10. There should be a provision of hearing and handling grievances related to wages.

11. Wages should be paid in time and wage rates revised periodically. For this a wage committee should be appointed.

12. Finally, wages should be such that they attract, motivate and retain competent personnel.

Employee Compensation – 2 Popular Types

Type # 1. Direct Compensation:

Wages are direct compensation; paying wages is obligatory, and hence, is a standard practice in organi­zations. Competitive advantage can only come by paying a higher amount.

There are many alternatives to direct compensation:

i. Incentive Pay:

A bonus paid on meeting specified performance objectives which are likely to inspire employees to set and achieve a higher performance level and is an excellent motivator to accomplish company goals.

ii. Stock Options:

A right to buy a part of the business which may be given to an employee to reward an excellent contribution to the company. An employee, who owns a share of the business, is far more likely to go an extra mile getting this indirect compensation.

iii. Bonuses:

A gift given periodically or occasionally to reward exceptional performance or in special occasions. Giving bonuses show that an employer appreciates his/her employees and ensures that good performance or special events are rewarded so that employees repeat the performance. Some indirect compensation elements are required by law, such as, social security, and unemployment and disability payments.

Other indirect elements are up to the employer and can offer excellent ways to provide benefits to the employees and the employer as well. For example, a working mother may take a lower-paying job with flexible hours or work from home. These facilities allow the employee to be home when her children get home from school.

In a competitive business scenario and scarce labour market, indirect compensation becomes increasingly important. Businesses that cannot compete with high cash wages can offer very individualized alternatives that meet the intrinsic needs of the people you want to employ. Small businesses can gain competitive advan­tage by providing such creative compensation alternatives which they can afford.

Type # 2. Indirect Compensation:

Some items are categorized as part of indirect compensation. A short list is provided for reference-

i. Clothing

ii. Cellular phones/pagers

iii. Child care

iv. Company parties

v. Farm produce/foods/meals

vi. Flexible working schedules

vii. Insurance (health, dental, eye)

viii.Laundry service

ix. Magazine and newspaper subscriptions

x. Travel expenses

xi. Old age care

xii. Paid leave (sick/holiday/personal days)

xiii. Retirement programs

xiv. Subsidized housing

xv. Subsidized utilities

xvi. Tickets to events (ball games, concerts, and other recreational events)

xvii. Use of farm pastures and gardens

xviii. Use of farm trucks and machinery.

Employee Compensation – Objectives of Effective Compensation System

Compensation bridges the gap between organizational objectives and individual expectations and aspirations.

An effective compensation system should have the following objectives:

(i) To pay sufficiently to fulfil basic needs.

(ii) To mark the compensation based on external labour market.

(iii) To maintain salary equity among employees.

(iv) To reward employees’ past performance.

(v) To align employees’ future performance with organizational goals.

(vi) The treat employees according to their performance.

(vii) To control compensation cost.

(viii) To attract as well as retain new employees.

Employee Compensation – 3 Common Mistakes While Designing Compensation Packages

While designing compensation packages, three common mistakes generally occur:

1. Failure of the organizations to distinguish between a bonus and an incentive. An incentive is linked with some measurable outcomes. Nevertheless, in India, we make payment of bonuses to meet statutory requirements and avoid labour unrest. The Indian Railways, Ordnance Factories, Post and Telegraph departments pay productivity-linked bonuses.

In compensation management literature, we view bonus as a price for the best efforts, which contributes to organization outcomes. It is more productivity-linked and performance-driven. Bonus is never based on individual performance; it is the collective output of all the employees. Hence, including bonus as compensation component encourages employees to expect it as a right.

2. Organizations often attempt to solve compensation claims on an adhoc basis. The second mistake in compensation design occurs due to this inclination of organizations. Moreover, organizations create an imbalance in internal pay equity when they try to compromise with their talent by overpaying. Thus, it is better for the organization to adopt a strategic approach, while designing compensation for their employees.

3. The equity compensation plans should be simple without any ambiguity. Additional mistakes are likely to occur if the compensation design is complicated.

While planning compensation, adequate care must be taken to avoid the faults described here.

Employee Compensation – 7 Major Issues

The major issues in compensation are equal pay, wage-rate compression and low salary budgets.

1. Equal Pay:

Generally, jobs performed predominantly by women are paid less than those done by men. This is gender discrimination. The issue of comparable worth, that is, male and female jobs that are dissimilar, but equal in terms of value or worth, should be compensated equally, goes beyond providing equal pay for jobs that involve the same duties for women as for men. The issue is that jobs held by women are not compensated the same way as those held by men, even though both types of jobs may contribute equally to the success of the organization.

To set right the gender discrimination, wages should be equal for jobs that are almost similar in contributing to the organization’s success. But present job evaluation techniques only help continuing the discrimination.

2. Wage-Rate Compression:

It is also known as delayering and banding. The primary purpose of the pay differences among the different groups/classes is to provide an incentive for employees to prepare for and accept more challenging and difficult jobs. But, this incentive of paying higher for more difficult jobs is reduced by wage-rate-compression. Wage-rate compression is the reduction of differences between job classes.

It is done mostly to have internal pay-equity. The problem occurs when employees feel that the difference between their compensation and that of their colleagues in lower-rated jobs is too narrow. Wage-rate compression often occurs when organizations award pay adjustments for lower grades without providing similar awards for higher grades.

Wage-rate compression can be reduced considerably by considering the following suggestions:

(i) Giving higher compensation to higher-grade employees than lower-grade employees.

(ii) Emphasizing the need for pay-for-performance and rewarding only performers.

(iii) Avoiding recruitment of employees on exorbitant salaries.

(iv) Formulating the pay structure in such a way that there is vast difference in compensation between new comers and senior employees as well as between lower-grade employees and higher-grade employees.

(v) Designing a mechanism to compensate adequately the employees who are adversely affected by pay compression.

3. Low Salary Budgets:

When the budgets are low, adequate compensation formula cannot be implemented. Consequent to cost-cutting strategy of companies, global competition for jobs, labour-saving technologies, and trend to use temporary and part-time employees has increased compensation is slowly getting reduced. Lower compensation may result in increased turnover and diminished employees’ output.

4. Effect of Inflation:

Inflation significantly influences compensation formula. For example, if the inflation rate is 6%, the company that fails to increase its salary ranges over two-year period will be 12% behind its competitors. Hence, all organizations must make some allowance for inflation in their compensation programmes.

5. Pay Secrecy:

Some organizations prefer to maintain pay secrecy i.e., employees may not know what exactly others get. But it is not that easy-to maintain secrecy in compensation. Pay secrecy may lead to distrust. A good relationship between employees and management can be built when the compensation policy and formula are made known to all. However, there are a few problems.

(i) When compensation is subjective, it is difficult for the management to defend the pay decisions.

(ii) In case of any false decisions, the organization’s weaknesses will become visible.

(iii) As management is required to explain in case of vast differences in pay-for-performance there may be wage-rate compression which may discourage good performers.

Open-pay policy may be adopted when performance can be measured objectively, performance measures can be developed for all the important components of a job and there is close association between effort and performance.

6. Problems with Job-Based Pay:

Job-based pay structures have many potential limitations.

(i) It may increase bureaucracy. People may refuse to do a task which is not included in the job description.

(ii) This encourages a top-down decision making which may ignore the advantage of skills and knowledge at lower levels.

(iii) The bureaucratic system may become a barrier for flexibility.

(iv) This may not reward designed behaviours in a changing environment where expected behaviours change often.

(v) People may concentrate only on promotion-seeking behaviours and refuse to accept lateral jobs.

7. Problems with Skill-Based Pay:

Skill-based-pay structure also has some potential problems.

(i) Though this plan will likely enhance acquisition of skills, the skills may not be used effectively resulting in higher labour cost but with little pay-off.

(ii) If employees acquire all the skills quickly there may not be any reason for further pay growth.

(iii) It is difficult to describe and measure to assign monetary values for skills.

(iv) Obtaining comparison data from other organizations is difficult.

Government Regulations:

Government regulations which prohibit gender-and race-based differences make it difficult for organizations to implement pay-for-performance effectively. Similarly Minimum Wage Act, which stipulates that the organization must pay the minimum legally allowed pay, makes it difficult to implement pay-for-performance programme adequately as some pay must be paid whether an employee performs or not.