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Chapter 7
Total Rewards and Compensation
Chapter Overview
Total rewards including compensation systems in organizations must be linked to organizational
strategies. Compensation remunerates employees for their knowledge, skills, and abilities
through:
Base pay
Variable pay
Benefits
The chapter opens with a discussion of the nature of total rewards and compensation regarding
the components of compensation, compensation philosophies, and compensation responsibilities.
Then the legal constraints on pay systems are explored. Particular attention is given to the Fair
Labor Standards Act (FLSA) with its coverage of minimum wage, child labor provisions, exempt
and nonexempt statuses, overtime, and common overtime issues for employees in the private and
public sectors. Other issues addressed include Equal Pay Act, Lilly Ledbetter Fair Pay Act,
independent contractor regulations, and garnishment laws.
Next, the chapter discusses the strategic compensation decisions including compensation
philosophies, communicating pay philosophy, compensation responsibilities, HR resource
metrics and compensation. Then, compensation system design issues are explored including
motivation theories and compensation philosophies, compensation fairness and equity (external
equity, internal equity, and pay secrecy), and market competitive compensation (lag-the-market,
lead-the-market, and match-the-market strategy).
Next, the chapter discusses the global compensation issues and the compensation plan for
international assignees. The chapter continues with a discussion on development of a base pay
system using the compensation philosophy and job analysis. The process incorporates
information gathered while valuing jobs and analyzing pay surveys—activities designed to
ensure that the pay system is both internally and externally equitable and in line with the
organizational philosophy. The two general approaches for valuing jobs are job evaluation and
market pricing. A description of the various types of job evaluation methods (ranking method,
classification method, factor-comparison method, and point factor method), market pricing, pay
surveys (internet-based pay information, using pay surveys, pay surveys and legal issues) are
also explored.
The importance of combining data from pay surveys and job evaluations to develop pay
structures is then detailed. The establishment of pay grades, pay ranges, and individual pay issues
(red-circled employees, green-circled employees, and pay compression) are discussed. The
chapter ends with a discussion on determining pay increases and describes performance-based
increases and standardized pay adjustments such as seniority, cost-of-living adjustments
(COLA), across-the-board increases, and lump-sum increases (LSIs).
Chapter Outline
Companies address pay and benefits with a total rewards philosophy. The total rewards package
includes all forms of compensation which are the monetary and nonmonetary rewards provided
by a company to attract, motivate, and retain employees.
I. Nature of Total Rewards and Compensation
Several strategic decisions guide the design of compensation practices:
Legal compliance with all applicable laws and regulations
Cost-effectiveness for the organization
Internal and external equity for employees
Figure 7-1 identifies elements of three primary components of the total rewards package.
A. Components of Compensation
Tangible rewards can be measured and it is possible to calculate the monetary value of each
reward. However, intangible rewards cannot be as easily measured or quantified. The
One tangible component of a compensation program is direct compensation, the monetary
rewards for work done and performance results achieved. Base pay and variable pay are the
Base Pay
The basic compensation that an employee receives, usually provided as an hourly wage or
a salary, is called base pay. Many organizations use two base pay categories, hourly and
Variable Pay
Another type of direct pay is variable pay, which is compensation linked directly to
Benefits
A benefit is an indirect reward—for instance, health insurance, vacation pay, and
II. Laws Governing Compensation
Pay practices are regulated by several key laws that address issues such as overtime pay,
A. Fair Labor Standards Act (FLSA)
The primary federal law affecting compensation is the Fair Labor Standards Act (FLSA),
which was passed in 1938. Compliance with FLSA provisions is enforced by the Wage and
Hour Division of the U.S. Department of Labor (DoL). Penalties for wage and hour violations
Minimum Wage
The FLSA sets a minimum wage to be paid to a broad spectrum of covered employees. A
lower minimum wage is set for “tipped” employees, such as restaurant servers, but their
Child Labor Provisions
The child labor provisions of the FLSA set the minimum age for employment with
Exempt and Non-exempt Statuses
Under the FLSA, employees are classified as exempt or nonexempt. Exempt employees
hold positions for which employers are not required to pay overtime. Nonexempt
employees must be paid overtime. The current FLSA regulations used to establish whether
When designing base pay, employers often categorize jobs into groupings that tie the FLSA
status with the method of payment. Employers are required to pay overtime for hourly jobs
Overtime
The FLSA established overtime pay requirements at one and one-half times the regular pay
The workweek is defined as a consecutive period of 168 hours (24 hours × 7 days), which
does not have to be a calendar week. Hospitals and nursing homes are allowed a special
Common Overtime Issues
For individuals who are nonexempt, employers must consider the following issues:
Compensatory time off—“comp” hours are earned by public-sector nonexempt
employees in lieu of payment for extra time worked at the rate of one and one-half
Incentives for non-exempt employees—employers must add the amount of direct
Training time—time spent in training must be counted as time worked by non-
Travel time—travel time must be counted as work time if it occurs during normal
Donning and doffing time—some jobs require employees to change clothes or to
spend a significant amount of time donning protective equipment before they report
The FLSA does not require employers to provide breaks, lunch periods, or to pay double-
B. Pay Equity Laws
Title VII of the Civil Rights Act of 1964 prohibits discrimination based on race, color, sex,
Equal Pay Act of 1963
The act prohibits companies from using different wage scales for men and women
performing substantially the same jobs. Pay differences can be justified on the basis of
Lilly Ledbetter Fair Pay Act
This law was enacted in 2008 in response to a Supreme Court decision restricting the
statute of limitations allowed under the Equal Pay Act for claiming pay discrimination
based on sex. Under the Equal Pay Act, an employee alleging discrimination had up to 300
C. Independent Contractor Regulations
The growing use of contingent workers by many organizations has drawn the attention of
several enforcement agencies such as the Internal Revenue Service (IRS), DoL, U.S. Treasury
For an employer, classifying someone as an independent contractor rather than an employee
Most federal and state entities rely on the criteria for independent contractor status established
D. Additional Laws Affecting Compensation
Several compensation-related laws apply to firms that have contracts with the U.S.
government. These laws require that federal contractors pay the prevailing wage, which is
Garnishment occurs when a creditor obtains a court order that directs an employer to set
aside a portion of an employee’s wages to pay a debt owed to the creditor. Regulations passed
III. Strategic Compensation Decisions
A. Compensation Philosophies
There are two basic compensation philosophies that are situated at opposite ends of a
continuum (Figure 7-3). At one end of the continuum is the entitlement philosophy; at the
Entitlement Philosophy
The entitlement philosophy assumes that individuals who have worked another year are
entitled to pay increases with little regard for performance differences. When organizations
Performance Philosophy
A pay-for-performance philosophy assumes that compensation decisions reflect
performance differences. Organizations using this philosophy do not guarantee additional
B. Communicating Pay Philosophy
Sharing the organizational pay philosophy helps employees to recognize the value of the total
reward package provided and shows how their job performance might affect their
C. Compensation Responsibilities
HR specialists and line managers work together to administer compensation expenditures. HR
specialists develop and administer the organizational compensation system and ensure that
Payroll Administration
Calculating pay and ensuring timely, accurate payroll processing is particularly important
D. Human Resource Metrics and Compensation
Employers spend a substantial amount of money on employee compensation. Just like any
The raw data needed to calculate various measures may be found in many organizational
functions. Wage rates, total payroll costs, and overtime information can be obtained from the
payroll staff or vendor. Productivity numbers may be logged by the Operations Department.
IV. Compensation System Design Issues
Depending on the compensation philosophies, strategies, and approaches used by an
organization, many decisions are made that affect the design of the compensation system.
A. Motivation Theories and/or Compensation Philosophies
Two theories of motivation in particular influence the design of compensation systems.
Expectancy Theory
According to expectancy theory, an employee’s motivation is based on several linked
concepts. This theory emphasizes the importance of finding rewards that are valued by the
Equity Theory
The equity theory of motivation states that individuals judge fairness (equity) in
compensation by comparing their inputs and outcomes against the inputs and outcomes of
B. Compensation Fairness and Equity
Most people work for monetary rewards. Whether they receive base pay or variable pay, the
extent to which employees perceive their compensation to be fair often affects their
performance and how they view their jobs and their employers.
External Equity
If an employer’s rewards are not viewed as equitable compared to other organizations, the
Internal Equity
Internal equity means that employees are compensated fairly with regard to the knowledge,
skills, and abilities (KSAs) they use in their jobs, as well as their responsibilities,
accomplishments, and job performance. Two key issues are important to internal equity
are:
Procedural justice—it is the perceived fairness of the process and procedures used
Distributive justice—it is the perceived fairness in how rewards are distributed.
To address concerns about both types of justice, some organizations establish
compensation appeals procedures.
Pay Secrecy
Another equity issue concerns the degree of secrecy organizations have regarding their pay
systems. Individual pay information may be kept secret in “closed” systems and might
C. Market Competitive Compensation
Whether an organization’s total reward practices are competitive has a significant impact on
employees’ views of compensation fairness. Providing competitive compensation to
Many organizations establish policies about where they wish to be positioned in the labor
Lag-the-Market Strategy
An employer using a first-quartile strategy chooses to “lag the market” by paying below
market levels for several reasons. If the employer is experiencing financial difficulties it
may be unable to pay more. Also, when an abundance of workers is available, particularly
Lead-the-Market Strategy
A third-quartile strategy uses an aggressive approach to “lead the market” in pay. This
Match-the-Market Strategy
Most employers position themselves in the second quartile (median), the middle of the
market, as determined by pay data from surveys of other employers’ compensation plans.
