What is retroactive pay? How to calculate it

Payroll managers understand the critical importance of accurate and timely employee payments. Proper payroll management transcends compliance—it's foundational to fostering trust and loyalty among the entire staff, whether hourly or salaried.

However, payroll is often a complex facet of business operations, and challenges can arise in any pay cycle. Retroactive pay, or retro pay, is implemented when there's a discrepancy in payment calculations, such as a delay in reflecting a salary increase in an employee's actual wages.

Retro pay vs. back pay: What’s the difference?

Retroactive pay and back pay are related yet distinct terms. Retroactive pay is issued when an employee has been compensated at a rate lower than they should have been, often due to payroll delays or errors that result from minor mishaps, like out-of-sync systems.

To correct this, companies may include the retroactive pay owed in the employee’s forthcoming paycheck or opt for a special one-time payment.

Conversely, back pay is due to greater issues, like unpaid overtime, minimum wage violations, or disputes between the employee and employer. These situations usually stem from more severe circumstances, including legal disputes. Back pay is generally settled following a legal verdict or dispute resolution, marking a distinction in the reasons behind these two types of compensation.

How is retroactive pay calculated and processed?

Retroactive pay should be clearly identified and processed in accordance with the Generally Accepted Accounting Principles (GAAP), as endorsed by the U.S. Securities and Exchange Commission (SEC).

Using GAAP, let's examine two scenarios to understand the retro pay process for hourly employees and those on a fixed salary.

Hourly staff

An hourly employee was slated for a raise from $15 to $16.50, retroactive to two biweekly pay periods ago. During that time, they worked 180 hours, 90 hours per pay period.

To calculate their retro pay, we first need to know:

• Their previous hourly rate ($15)
• Their new hourly rate ($16.50)
• The effective date of the pay increase
• The total number of hours worked at the old rate

The next steps are:

• Calculate the hourly increase amount ($1.50 in this case)
• Multiply the total hours worked at the former rate by the hourly increase (180 hours multiplied by $1.50 = $270)

The hourly employee should receive $270 in retro pay.

Salaried staff

Suppose an employee received a 6% salary increase, which took their annual salary from $58,000 to $61,480. The gross pay adjustment was scheduled to start from the last biweekly pay period, but due to an error, they continued to receive their original salary. 

To calculate their retro pay, we first need to know:

• Their previous annual salary ($58,000)
• Their new yearly salary ($61,480)
• The effective date of the salary increase

The next steps are:

• Calculate their original biweekly salary: $58,000 divided by 26 (the number of biweekly pay periods in a year), which equals $2,230.77
• Calculate the new biweekly salary using the same method ($2,364.62)
• Find the difference in biweekly salaries by subtracting the original biweekly salary from the new biweekly salary to get the difference between these numbers ($2,364.62 - $2,230.77 = $133.85)
• Multiply by the number of biweekly periods affected (because it’s just one pay period, the total remains $133.85)

The salaried employee should receive $133.85 in retro pay.

Why might you need to process retro pay?

Let's explore the typical reasons why retroactive pay adjustments might be necessary:

• Payroll errors: Sometimes, incorrect data input or miscalculations by payroll teams and payroll software lead to employees receiving inaccurate pay.
• Salary adjustments: Delays in approved pay raises in the payroll system can necessitate retroactive compensation.
• Promotions or job reclassifications: A pay rate increase accompanying a promotion or job change might take time to update in the payroll records.
• Overtime pay adjustments: Inaccuracies in the payroll process of calculating overtime could result in wages owed to employees.
• Commission or bonus discrepancies: Occasionally, the initial computation of sales commissions or performance bonuses may not align with the agreed terms, requiring later correction.

Simplify international payments with Oyster

Managing and distributing retroactive pay can be a significant administrative challenge, especially when it involves many employees. Oyster HR simplifies the process, making it easier to establish compensation policies and pay staff in more than 180 countries, reducing the likelihood of errors that necessitate retro pay.

With Oyster, businesses can expand, oversee, and compensate their global teams effortlessly without needing in-depth knowledge of local labor laws or tax regulations. Organizations leveraging Oyster also gain access to top talent worldwide without having to establish local entities in every country.

Oyster’s suite of services and tools ensures you maintain full compliance and eliminate the complexities and burdens traditionally associated with managing an international workforce.

Discover how Oyster can help scale your organization beyond borders today.