As a business owner, you are responsible for ensuring every employee is paid correctly and on time. However, payroll mistakes happen. If you underpay one of your workers during a pay period, you owe them retro pay the following paycheck.
What is retro pay?
Retro pay, short for retroactive pay, is when an employer owes money to an employee for work they performed during a previous pay period, which was incorrectly calculated at that time on the employee's paycheck. Retro pay compensates the employee the difference between what they should have been paid by you and what they received; retro pay, when it is discovered, should be calculated and included in the employee's next paycheck.
Retro pay is, generally, an uncommon occurrence for small businesses. However, it can happen, and when it does, it should be communicated to the employee and promptly fixed. If several pay periods have passed when the discrepancy occurred, you should add retro pay to the next paycheck once it is discovered.
"When possible, it's best to first let the employee know in person when a pay error has been made," said Karen Oakey, director of human resources for Fracture. "Then, follow up with an email. Take the personal approach first and see if there are any immediate questions."
When do employers pay retro pay?
Here are a few common reasons why an employer would need to retroactively pay an employee.
Pay raises
If an employee is given a pay raise, a common occurrence is that the new salary is not entered into the payroll system. Payroll may be underway when the new salary is agreed upon and cannot, therefore, be changed. An organization's accounting team can easily apply the employee's new raise retroactively for the next pay period.
Additionally, there are some instances where a pay raise may be retroactive. For example, if an employee is due to receive an annual pay increase on July 1, but the amount of the raise isn't determined until August, the increase they should have received might be retroactive to July 1.
Miscalculated earnings
Even though payroll is run countless times, mistakes can still happen in the system. An incorrect pay rate or total number of hours worked could be entered, skewing the employee's paycheck. This is a good reminder that employees should check their pay stubs to make sure they are properly compensated.
Commissions
Some employees, particularly those who work in sales, earn commissions based on meeting or exceeding specific goals. For example, if an employee exceeds target sales numbers for a quarter, they may be entitled to additional income. If commissions, however, are not automatically calculated, it could be missed and, therefore, has to be entered manually into your payroll system.
Shift differentials
If an employee works a different shift that pays a different hourly rate or they work overtime, that change in pay type may get missed. Shift differentials occur when an employee is paid at a higher rate to work outside their normal business hours, such as a graveyard shift. For overtime, when an employee works over 40 hours in a week, their hourly rate increases by 1.5. Because the employee's rate is different, the payment can get missed.
Multiple pay rates
Some organizations have different pay rates depending on the job they are doing. If an employee is working two or more different positions within the organization and earns different pay rates for them, the wrong rate may be submitted when running payroll.
Bonuses
Similar to commissions, an employee can earn a bonus during a pay period, but it may take a few pay cycles to get properly recorded in the accounting system.
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Back pay vs. retro pay
Back pay is another common payroll mistake, and it is often confused with retro pay. There are some distinctions between the two.
Back pay
Back pay is when an employee is owed wages by their employer that were never paid to them.
The difference between back pay and retro pay is that back pay is for wages that were altogether missed and never paid to the employee. In the case of back pay owed to a worker, you can either run a separate payroll check for them or include the missing wages on their next paycheck.
Retro pay
Retro pay is when an employer makes up the difference – or shortfall – between wages the employee should have been paid versus what the employee received during the pay period in question.
Retro pay corrects payroll mistakes and miscalculations, whereas back pay compensates an employee for missed wages.
How to calculate retro pay
Hourly employees
When determining retro pay for an hourly employee, you first need to know what the error was. Once you know the correct rate and the right number of hours the employee worked, multiply the differential rate by the hours paid and calculate the gross retroactive pay amount.
Since retroactive payments are added to the employee's next paycheck, remember to add the amount owed in retro pay to the amount they are owed for the current pay period. If the total number of hours exceeds 40, you'll have to decide how to make the payment, as an overtime payment be needed.
Salary employees
Since salaried employees don't have a set rate, it can be tricky to determine their retro pay. First, you need to calculate the difference between the annual salary they were paid and the salary they should have been paid. Then, verify the number of bill days in the year to get the accurate rate.
Calculating retro pay can be complicated, especially for salaried employees. When doing so, try to use payroll software or a free online paycheck calculator to ensure accurate calculations.
How does retro pay impact taxes?
Even though it is a correction to a previous paycheck, any retroactive payment must be taxed. Wages from retro pay are subject to the same rates as an employee's regular wage. As the employer, you need to withhold Social Security and Medicare (FICA), federal income tax, and, when applicable, state and local income tax.
As retro pay is a type of supplemental pay, you should use the percentage or aggregate method to withhold federal income tax from that supplemental wage. FICA tax is withheld, too.
Companies should consult their state government about how to calculate state and local income taxes on retro pay. If you issue a separate check instead of adding the retro pay to the employee's next paycheck, that payment is still subject to the same taxes.