Retroactive Pay Explained: How it Works and Why it Matters

Retro Pay, short for Retroactive pay, refers to money owed to an employee for work they have already performed. In this article, you will learn about the reasons why retroactive pay may be needed, how it works, and all the laws and regulations you need to consider when issuing retro pay.

Most companies have to issue salary adjustments - or retro pay - at some point, for many reasons. That means you need to understand this issue before you encounter it.

Retro pay, short for retroactive pay, refers to money owed to an employee or a group of employees for work they have already performed. It is added to an employee’s paycheck or issued on a different paycheck to make up for a compensation shortfall in a previous pay period. This can happen for a number of reasons, the most common being a payroll error. Retroactive pay is different from back pay, which refers to compensation that makes up for a pay period where an employee received no compensation at all.

Knowing about retro pay or retroactive payroll adjustments is very important, as it occurs when an employee was not properly compensated in the first place. Understanding what retro pay is and being able to calculate and send it as quickly as possible will help ensure that your company complies with labor laws and that your employees remain happy and productive.

When your business has a cohesive accounting department, you don’t often have to use retro pay. However, there are specific situations that require you to know how to issue retroactive pay. Generally, these situations are due to a newly negotiated contract or an accounting mistake. Here are some of the reasons why you may need to issue retro pay.

When an employee works two or more positions in an organization, for which they earn different pay rates, a mistake when issuing their payroll may occur. It can also happen that an employee works extra shifts besides their normal schedule and the accounting department forgets to increase their rate.

This is the most common reason why businesses need to issue retro pay. Most of the time, overtime hours for hourly employees are paid at a greater rate than normal hours (1.5 times greater). Because of miscommunication, payroll departments often forget to change the rate when calculating employees’ wages and have to issue retro pay to make up the difference.

A change in employee’s status requires your business’ payroll department to adjust their wages which they may not do or get delayed in doing. Another example would be an employee who receives a commission for their work. With some accounting methods, a client who pays late may delay the payment of that commission. Finally, when an employee receives a bonus for a pay period, they may have to wait until the next pay period to receive it.

Calculation errors in paychecks mainly occur in businesses that don’t use a payroll software solution to digitally calculate salaries and wages accurately. Even then, a technical glitch could cause errors, or the payroll department might enter an incorrect pay rate or a wrong number of hours worked on an employee’s timesheet.

If a termination takes place and it’s ruled a wrongful termination by a court of law, you’ll need to issue retroactive pay or back pay - depending on the situation - and hire back the employee.

Fortunately, the calculation of retroactive pay is not much different from the calculation of regular pay period payments. When calculating retro pay for an employee, you need to consider the following:

• Dates and duration: how many pay periods are concerned? What are the start and end dates?
• How many hours a week did the employee work? This factor doesn’t apply to a salaried employee as they are usually paid the same amount for each pay period.
• How much did you pay them during the pay period?
• What is the correct amount you should have paid them?

To get a figure for retro pay, simply calculate the difference between the amount paid and the amount the employee should have received. You’ll have to base the calculations on gross and withhold taxes afterward.

As per US government rules, retroactive pay is taxed exactly the same as regular pay. Employers must withhold:

• Social Security and Medicare taxes (FICA)
• State income tax (if applicable)
• Local income tax (if applicable)
• Federal income tax

There are several ways you can issue the payment:

• Create a Separate Payroll Run titled RETRO
• Include the Payment in the Next Paycheck, in a separate section (label it RETRO to avoid any confusion)
• Increase Pay on the Next Paycheck: This option is similar to the second option, except you add the amount of the retro pay to your employee’s regular pay without separating both amounts.

Retro pay is used as a correction when an employer paid an employee less than they should have. Therefore, retropay benefits both the employer - who gets back on the right side of the law - and the employee - who receives the wages they have worked for.

Being owed money by an employer can be very stressful and uncomfortable for an employee, and can even cause financial issues if we are talking about a large amount.

Issuing retro pay can also be stressful for small businesses if they owe a large amount. Over a long period of time, small amounts may add up to a total that is difficult for a small business to pay at once.

Salary transparency and open conversations around pay practices are very important as they help create a more positive work environment, and foster greater employee satisfaction and motivation.

Being transparent makes it clear to your employees that they are always paid for their work and efforts and are never devalued or discriminated against.

In some cases, a court can legally order a business to provide retroactive pay. Here are some circumstances when a judge may order retro pay:

• Discrimination: a group of employees receives preferential compensation treatment over another based on race, gender, age, or other protected status.
• Breach Of Contract: an employer intentionally fails to pay the employee the rate stated in their contract.
• Retaliation: a business owes wages because an employee was fired for whistleblowing.
• Failure To Pay Overtime: an employer intentionally fails to pay for overtime.
• Minimum Wage Violations: an employer pays employees less than the minimum wage.

State laws regarding retroactive pay may vary greatly. Review the state laws and all other local regulations that may apply to your business to avoid any mistakes. Here are two important specific state laws you might want to consider:

• In some states, such as New Mexico and Texas, employees of state agencies or institutions of higher education are not allowed under any circumstances to receive retroactive payments.

• California: Whether the payroll concerns retroactive pay or back pay, employers must make sure the payroll statement clearly includes the payroll dates. If it doesn’t, employees have the right to sue their employers. Retroactive pay is not allowed in the state of California for any public official, employee, or contractor after providing a service or completing a contract.

Let's take the example of James, who is a salaried employee of an accounting firm.

His annual salary is $30,000. He received a $5,000 raise, but his employer forgot to run the payroll using the employee's new salary rate. James was entitled to retroactive pay for each pay period - which amounted to $192.30 in retroactive pay for each pay period (26, paid bi-weekly)

Now let’s look at what happened to Emilie. New to the company where she worked, Emilie agreed to work overtime on several occasions, but this was not reflected in her pay slip. The court ordered retro pay stating that her employer had failed to pay Emilie appropriately based on her overtime rate. (Overtime is time and a half, according to Fair Labor Standards Act [FLSA]). Unfortunately, this is a common legal violation.

What we have learned from retroactive pay disputes and real-life cases is that employees should always check their payroll for potential mistakes, and that employers should use time-trackers and payroll automation to avoid mistakes and potential disputes.

State laws and local regulations can greatly vary when it comes to retroactive pay and labor laws in general. That is why you should contact a local and experienced attorney or employment lawyer as soon as you experience an issue or dispute with retro pay in your organization. Doing so will help you understand specific laws that apply to your business and remain in compliance with all laws and regulations in your state.

Payroll errors do occur every now and then. Mistakes happen, and payroll errors are almost always an accident. The most important thing here is to correct this mistake as quickly as possible by issuing a retroactive pay. This keeps your employees happy and productive as you treat them fairly and pay them what they are worth.

Certain tools, software and systems can help you streamline your payroll and accounting processes to avoid making mistakes whenever they are avoidable. When these errors occur anyway, accounting and payroll systems will also help you identify them quickly and resolve them with ease. Basically, these tools help you stay organized and accurate.