THE PAYROLL DETECTIVE: CRACKING THE CASE OF INCENTIVE BONUSES AND REGULAR RATE PITFALLS

by Victoria Dolan

Welcome back to The Payroll Detective, where we investigate mysteries that baffle even seasoned HR and payroll pros. Today’s case? “The Curious Case of the Incentive Bonus.” Our mission: to help you distinguish incentive payments from discretionary bonuses and uncover how to structure them to sidestep regular-rate-of-pay traps laid by the California Labor Code and IWC Wage Orders when paying bonuses to nonexempt employees. Let’s get to work.

The Case File: Discretionary vs. Nondiscretionary Bonuses
Under California law, nonexempt employees must receive overtime pay based on the regular rate of pay — and this rate includes all forms of compensation, unless specifically excluded.

Sound familiar? Here’s the twist: California takes a narrower view than federal law. It’s even more critical to properly classify bonuses.

Truly discretionary bonuses are rare and must meet strict criteria to be excluded from the regular rate calculation. A bonus is discretionary if:

  • The employer has sole discretion over whether to pay it (and how much)
  • The amount is not determined by prior agreements or expectations
  • It’s not tied to measurable goals like attendance, production, or sales targets (this includes employee referral programs)

Example: a holiday bonus given at the employer’s whim, with no employee expectation, or formula, is likely discretionary.

Beware: The moment the bonus becomes linked to performance, productivity, longevity, or any condition, it’s likely considered a nondiscretionary incentive — and therefore must be included in the regular rate of pay for calculating overtime.

Payroll Detective Tips: Keeping Bonuses Truly Discretionary

  1. No Strings Attached: don’t tie the bonus to meeting goals or metrics
  2. Use Clear Language: state in writing that the bonus is “entirely discretionary and not earned based on performance or hours worked”
  3. Don’t Advertise It: marketing a bonus as a “perk” or “employee benefit” can make it appear expected and therefore nondiscretionary
  4. Avoid Predictable Patterns: don’t issue bonuses on a schedule — even holiday bonuses can become expected if they follow predictable patterns

The Dilemma

Let’s face it, incentives can be an effective tool for recognizing and rewarding desired performance in a fair and consistent manner.

That’s why many California employers rely on incentive bonuses tied to KPIs, production, or other performance-based goals. But here’s the compliance catch for nonexempt employees: these bonuses are considered nondiscretionary under the California Labor Code and IWC Wage Orders — which means they must be included in the regular rate of pay when calculating overtime.

Payroll Detective Fix: Structure Incentives as a Percentage of Gross Pay

The smart move? Design your incentive as a percentage of gross pay — inclusive of all earnings, including overtime — for the applicable period.

Example: Instead of paying a flat $600 bonus for hitting quarterly goals:

  • Pay a percentage of total gross wages (including OT pay) for that quarter

This approach automatically accounts for all hours worked — straight time and overtime — and eliminates the need for retroactive OT calculations:

  • The bonus automatically adjusts based on actual compensation
  • It’s proportional to all hours worked, including overtime
  • You avoid messy retroactive calculations and the risk of underpaid wages
  • It meets California’s requirement to include incentive pay in the regular rate

When the Bonus Is an Incentive: Solve the Regular Rate Puzzle

If you don’t take this approach and instead offer formulaic or flat-dollar performance bonuses, you’ll need to:

  • Recalculate the regular rate of pay for the entire bonus period
  • Pay additional overtime based on the increased rate
  • Possibly correct past pay periods if the bonus covers multiple weeks or months

This process can be complex, especially when bonuses are paid after the period has closed. Even small errors can trigger wage claims, waiting time penalties, or exposure under PAGA.

With a percentage-of-gross approach, you keep your incentive program fair, consistent, and compliant with California law — while saving time, payroll headaches, and legal risk.

Final Case Notes: California is Watching

Failing to include a nondiscretionary bonus in the regular rate of pay can expose your company to wage and hour claims, penalties, and back pay liability. But with the right detective work, you can:

  • Offer truly discretionary bonuses that are exempt from OT calculations; or
  • Craft well-designed incentive plans that automatically account for overtime.

Case Closed… For Now

Whether you’re a payroll sleuth or just dipping your toes into compliance waters, remember — how a bonus is structured matters as much as how it’s communicated. Keep your paperwork clean, your intent clear, and your bonus designs strategic.

Until next time — stay sharp, stay compliant, and remember: The Payroll Detective is always on the case.