As an employer, you're likely interested in ways you can further incentivize your employees outside generic practices like overtime pay. You want to give them even more reasons to work hard and invest in the success of your business.
This may have made you consider a discretionary bonus.
While there can be minor upsides in certain circumstances, this method has many serious flaws - especially when it's compared to profit sharing plans.
In this guide, we'll tell you exactly what a discretionary bonus is, how it works, and more.
However, we'll mainly be showing you why it's probably not the best option for you and your employees.
Discretionary bonuses are a type of bonus payment awarded to an employee at their employer's discretion. This means that there is no predetermined contract or plan in place for the bonus to be paid.
Generally, a discretionary bonus is awarded for things like completing challenging tasks, exceptional performance, and overachieving on targets.
Unlike other types of bonuses like referral bonuses, safety bonuses, and attendance bonuses, discretionary bonuses can be paid in any amount and at any time.
The reason employers sometimes pay bonuses in this way is because they believe it will boost morale, motivate their teams, and recognize their contributions. Yet, there are many downsides to such bonuses which we'll cover in detail later.
As mentioned, discretionary bonuses are in no way predetermined by a plan or contract. So, the timing of the payment and the amount of bonus money can be highly variable.
Non-discretionary bonuses, on the other hand, are predetermined payments employees know they'll receive if certain conditions are met.
Non-discretionary bonus plans are designed to incentivize employees to meet specific targets and provide them with achievable goals that must be reached for the bonus payments to be triggered.
Now you know what discretionary bonuses are and how they compare to non-discretionary bonuses - but how do they actually work?
Let's take a look at their impact on taxes and some of their key features to find out.
In the U.S., discretionary bonuses are considered supplemental income. They're taxed using either the aggregate or percentage method.
For the employee, the aggregate method can lead to a higher tax withholding than necessary. This could result in a lower take-home amount or tax refund.
For employers, discretionary bonuses offer some flexibility when it comes to tax planning. Since employers can choose the timing and amounts involved in the bonus program, they have some control over how it will affect the tax implications for both the employees and the employer.
Often, for tax purposes, a non-discretionary bonus is excluded from an employee's regular rate of pay which can be advantageous for tax planning.
Discretionary bonuses are flexible because they're paid at the sole discretion of the employer. This allows them to consider factors like company performance, budgetary constraints, and employee performance before deciding to award bonuses.
So, if an employer determines that the circumstances aren't right for the company to pay a bonus, they can choose not to.
An employer doesn't have this flexibility when it comes to non-discretionary bonuses. Regardless of the company's situation, they're contractually obliged to pay out these bonuses when the predetermined conditions are met.
The criteria for discretionary bonuses are not known by employees and are fully determined by the employer.
The criteria may be agreed upon by the management team and the bonuses paid when they're met. Or, there may not be any specific criteria, and the bonuses will be paid to employees who are performing well.
It's also up to the employer to calculate discretionary bonuses and decide on the bonus amount. The methods used to calculate discretionary bonuses vary greatly between organizations.
These decisions rest with the employer, and the bonus will always come as a surprise to the employee.
Compared to things like overtime pay, the unpredictability of discretionary bonuses can create employee uncertainty.
The fact they don't know if and when they'll receive a bonus can cause them to lose motivation and feel as if they won't be rewarded for their hard work.
We've already touched on why discretionary bonuses can be a poor additional compensation plan for employees. Now, we'll dive into exactly why this type of bonus simply doesn't work.
The lack of transparency and consistency regarding the discretionary bonus model can lead to:
One of the biggest downsides of the discretionary bonus is its ability to severely demotivate employees. It can do this in several ways, including:
Such bonuses can give rise to various legal and ethical considerations around non-discrimination, fairness, and transparency.
To avoid unethical practices and potential legal claims, employers need to establish clear bonus guidelines and carry out their decisions in good faith.
Discrimination must be avoided and the employer needs to provide clear reasoning for why a discretionary bonus has been paid to maintain transparency.
The rules around the discretionary element of these bonuses are laid out in the Fair Labor Standards Act (FLSA). It states that the employer must make decisions around the timing and amount of the payment right before it's made.
Essentially, this means that legally the payment must come as a surprise to the employee and not give the impression that they can expect these payments regularly.
A profit sharing bonus, or plan, involves a company sharing a percentage of the business's profits with its employees.
Unlike discretionary bonuses, the timing and amount are predetermined and are based on quarterly or annual earnings.
As the funds are generated from the company's profits, the employee doesn't pay into a profit sharing plan like they would with a 401(k), for example.
The payments may be distributed as lump-sum bonuses or as part of employees' regular paychecks along with other things like overtime pay.
The eligibility criteria for profit sharing plans vary widely between companies but often include factors such as length of service and exceptional performance.
If you'd like to learn how to calculate profit sharing bonus payments for your employees, then our guide will tell you everything you need to know.
A profit sharing plan is one of the best employee incentive ideas for many reasons, including:
Here are some tips for implementing a profit sharing plan:
Some other types of employee bonus options are:
A performance bonus is directly tied to an employee's performance. Unlike a discretionary bonus, the employee knows what they need to achieve in order to receive it. However, performance bonuses can create pressure and unhealthy competition among colleagues.
Profit sharing plans are better than both as the payments are linked to the overall success and profitability of the company. The employee knows that if the business prospers, so will they.
Such bonuses are paid to employees who refer new hires to the company and are typically awarded after the new employee has been employed for a certain amount of time.
They're good for attracting new team members but have no impact on employee performance or motivation. Their purpose is different to both the discretionary bonus and profit sharing, and they don't have as many positives as either one.
A retention bonus is paid to employees who remain with a company for a certain amount of time and can be reasonably effective.
Yet, profit sharing is a much better way of improving retention rates as it encourages employees to remain at a company to share in its profits and overall success.
ShareWillow's profit sharing software allows you to design, customize, and manage your plan in one easy place.
It has a user-friendly interface that helps you make your plan as transparent as possible for your employees and features payroll and 401(k) integrations.
If you're ready to start creating your plan today, use our profit sharing plan template which will guide you through the process.
Don't rely on a discretionary bonus to motivate your team. A profit sharing plan has more benefits for your employees and, ultimately, your business.
This profit sharing plan excel template has everything you need to build and launch a profit sharing plan.
Download for freeDiscover innovative and effective profit sharing plans for your business in this comprehensive guide.
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