How to Calculate Bonus Pay & Taxes

Employee bonus pay is a way to thank your team for their hard work, show your appreciation, and incentivize them to hit targets. IGiving your team a bonus can boost employee morale, engagement, and overall productivity.

There’s one problem: It can be challenging to know how to calculate bonus pay and decide what type of bonus pay will work best for your team.

What’s more, knowing your tax obligations is crucial if you pay bonuses, and taxes can always feel intimidating and complicated for small business owners.

That’s why we’re here to help you.

In this article, you can follow a step-by-step guide to calculating bonus pay, learn the ins and outs of bonus pay laws, and the tax rate for bonuses in 2024—so you can stay compliant and focus on rewarding your team.

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What is bonus pay?

Bonus pay is additional compensation employees receive on top of their regular salary or wages.

It’s usually given as a reward for meeting or exceeding performance goals, contributing to business outcomes, or achieving a specific milestone. It can take the form of money, gifts, experiences, or other rewards.

You can reward bonus pay to all your team members or just a few. However, be aware of what you are contractually and legally obligated to do regarding employee bonus pay.

Bonus pay, also known as supplemental pay or income, can be run through payroll apps or calculated manually using a spreadsheet, but be aware—spreadsheets can be more time-consuming and leave room for error. 

Bonus pay can be a recurring or one-off payment. Some apps, like Homebase payroll, let you calculate both kinds.

Depending on the business, bonuses can make up a substantial portion of your employee’s income. They can also vary significantly based on industry. 

For example, in the US, the average bonus for a retail worker is 2.5% of the employee’s salary. In contrast, the finance industry offers bonuses of 20%.

What are the different types of bonus pay?

Types of bonus pay for small business owners fall into five categories:

Discretionary bonuses

A discretionary bonus is a special type of bonus pay given by an employer to an employee as a reward for exceptional performance or contributions. 

Unlike regular bonuses, discretionary bonuses are not guaranteed or based on specific criteria but are at the employer’s discretion and without prior agreement.

Some examples include:

• Cash gifts for the holidays
• On-the-spot, one-off bonuses for exceptional work
• Rewards-based performance bonuses

Non-discretionary bonuses

A non-discretionary bonus is a type of bonus pay that an employer must give an employee based on specific criteria or conditions. Unlike discretionary bonuses, which are given at the employer’s choice, non-discretionary bonuses are typically outlined in a contract or company policy.

These bonuses are given when specific goals are met, such as reaching sales targets or completing a project on time.

​​They may include:

• End-of-year bonuses
• Signing bonuses
• Referral bonuses
• Sales commissions
• Goal-based performance bonuses

Sign-on bonuses

A sign-on bonus is an incentive for new hires as part of their onboarding package. The purpose is to offer an attractive benefit to entice top talent in competitive job markets or to fill open roles quickly. 

Typically, the bonus amount depends on factors such as the industry, job level, and candidate's qualifications. 

Depending on company policy, the payment can be delivered upfront, in installments, or after a probationary period. Sign-on bonuses often come with stipulations, such as repayment clauses if the employee leaves the company within a certain timeframe. 

You can also use these bonuses to offset candidates' costs, such as relocation expenses or the forfeiture of benefits from a previous employer.

Retention bonuses

Retention bonuses are designed to retain employees for a specified period, particularly during organizational transitions or projects requiring sustained expertise, such as mergers, acquisitions, or restructuring efforts. 

The payment usually depends on the employee staying with the company until the end of the agreed timeframe. The amount of the bonus and the payment structure can vary based on the employee's role, tenure, and the importance of their contribution to the business. 

Retention bonuses encourage loyalty and signal your company’s recognition of an employee’s value.

Performance bonuses

A performance bonus is a reward given to employees based on individual, team, or company performance. This type of employee bonus aims to incentivize productivity, efficiency, and innovation by linking financial rewards to measurable outcomes, for example, achieving sales targets, exceeding project goals, or contributing to business profitability. 

Performance bonuses can take various forms, including cash payments, stock options, or other non-monetary rewards such as vacations or gift cards.

How to calculate bonus pay

Small businesses use different methods to calculate bonus pay based on their industry and specific business. Here are some common ones:

Bonus pay as a percent of salary

This method is used for managers, team leaders, or department heads who determine bonuses based on a percentage of each employee’s salary. The calculation involves multiplying the employee’s salary by the bonus percentage.

Here’s how to calculate bonus pay as a percentage of salary:

1. Determine the employee’s base salary
2. Decide the percentage to be given as a bonus
3. Calculate the bonus by dividing the bonus percentage by 100 and multiplying it by the base salary

For example, if an employee’s base salary is $60,000 and you have a 2% bonus outlined in your company policy, the bonus amount would be $1,200. 

Flat rate bonus

A flat-rate bonus is simple to calculate because, unlike performance-based bonuses, which fluctuate depending on individual or business achievements, a flat-rate bonus is an equal amount that each person in the company receives. 

Here’s how to calculate a flat rate bonus:

1. Determine the flat rate per person
2. Count the number of eligible employees
3. Multiply the bonus amount by the number of employees

For example, if the flat-rate bonus is $250 and you have 20 employees, you must pay $5,000 in bonuses.

Bonus pay as a sales commission

Small business owners use this method to reward salespeople. This type of bonus pay is a percentage of the sales revenue or a fixed amount awarded when certain sales targets are met, known as a tiered commission. 

Here’s how to calculate bonus pay as a percentage of sales revenue:

1. Determine the commission rate
2. Calculate the commission amount

For example, if a member of your sales team earns a 5% commission on total sales revenue and makes $10,000 in sales for the month, the calculation would be $10,000 x 0.05, which is $500 in bonus pay. 

Here’s how to calculate bonus pay using a tiered commission structure:

1. Calculate the commission for the first tier
2. Calculate the commission for the second tier
3. Add them together to calculate the total bonus pay

For example, let’s say your company awards 5% of the first $10,000 in sales and 10% of sales exceeding $10,000. 

• The first tier commission would be calculated as 10,000 x 0.05 = 500
• The second tier commission would be calculated as 10,000 x 0.10 = 1,000

Therefore, the total bonus pay would be $1,500.

Discretionary vs. non-discretionary bonuses

As a discretionary bonus pay example, let’s say you have a small retail store.

You have five employees: three full-time and two part-time. Your full-time staff works 35 hours a week, and your part-time staff works 10 hours a week.

Your bonus budget is $5,000 in total.

To keep your bonus payments fair, you calculate the following:

1. Everyone’s total hours: 35 + 35 + 35 + 10 + 10 = 125
2. The bonus amount is divided by that number: 5000 ÷ 125 = 40. (Each hour worked = $40)
3. The full-time workers’ hours multiplied by this rate: 40 x 35 = 1400
4. The part-time workers’ hours multiplied by this rate: 40 x 10 = 400

So, you’d give your full-time workers $1,400 each and your part-time workers $400 each.

This more accurately reflects each employee’s contribution to your business and is much less likely to cause resentment than simply dividing $5,000 by five.

Calculating non-discretionary bonuses isn’t the same as calculating discretionary bonuses. You need to use other formulas.

For one-off non-discretionary bonuses, you might decide on a suitable amount for the situation, your business size, and your industry. For example, salons might pay $1,000 for each employee referral that stays a customer for at least six months.

For recurring non-discretionary bonuses based on employee tenure, role, and performance, you have to get each individual’s data for every criterion and multiply their average monthly salary by those numbers.

Let’s say you run a small cafe with one manager. Cafe policy encourages higher sales by offering a non-discretionary bonus based on monthly sales targets. For example:

• Manager base salary: $3,000 per month.
• Monthly sales target: $20,000 in sales.
• Bonus rate: 5% of sales exceeding the target.
• Employee's sales performance: $25,000 in sales for the month.

Then, use the following calculation:

1. Determine the base monthly salary: $3,000
2. Calculate the nondiscretionary bonus:

• Sales achieved: $25,000
• Sales target: $20,000
• Sales exceeding the target: $25,000 - $20,000 = $5,000
• Bonus = $5,000 x 0.05 = $250

Your manager will receive $3,250 in compensation ($3,000 + $250 = $3,250).

How to process bonus pay and taxes

There’s no legal way to pay employees bonuses without taxes. You have three options for taxing and processing bonus payments:

1. Run separate bonus payroll (“the percentage method”).
2. Include the bonus in your regular payroll run and denote it (“the aggregate method”).
3. Include the bonus in your regular payroll, but don’t denote it (not recommended).

1. Run separate bonus payroll (“The percentage method”).

If you run a separate bonus payroll (as opposed to your regular payroll), employees will get their bonuses on a separate check.

You’ll have to withhold income tax at a rate of 22%—the flat withholding rate for all supplemental pay under $1 million in the United States. 

The bonus will also be subject to other regular payroll taxes, such as state taxes, Social Security, Medicare, FUTA, and SUTA.

Read this guide on must-know payroll taxes for small business owners for more information. 

Advantages of the percentage method

• Easy to calculate as a flat percentage, so it is less error-prone. And if you’re using Homebase payroll to calculate and send tax payments, you’ll spend very little time on the process.
• Employees may prefer it. They'll pay less tax if they’re in a tax bracket equal to or higher than 22%.

Disadvantages of the percentage method

• Some employees may not like this method. If a worker is in a lower tax bracket, it could result in over withholding.

In the above situation, the team members can claim the money back, but they’d probably prefer to avoid the paperwork. Also, getting a bonus now rather than later could significantly improve their finances.

That’s one of the reasons why the best way to pay employee bonuses is through the percentage method.

Small business payroll software like Homebase can run a bonus payroll quickly and easily. Follow these steps to get started:

1. In your Payroll dashboard, click Payroll Runs on the left dashboard.
2. Under Payroll Actions to the right of the screen, click Run off-cycle payroll.
3. This screen is where you choose which team members to include and the reason for the payroll (like bonuses).
4. Select the pay period and payday and choose whether to enter hours manually or import time cards.
5. You can then add time off, other earnings, and tips.
6. Hit Next to review and submit the run. Homebase will make sure that everything adds up correctly for you.

2. Include a bonus in your regular payroll run (“The aggregate method”).

When using the aggregate withholding method, bonuses should be paid through payroll. This means including them alongside your employees’ regular wages but clearly indicating them.

This method is more complicated but still manageable, especially if you have support from your payroll provider or use Homebase payroll.

To calculate your taxes with the aggregate method, take the following steps:

1. Calculate the income tax you must withhold on the combined regular pay and bonus.
2. Calculate the amount you need to withhold on your employee’s regular wages.
3. Subtract (2) from (1) to get the total tax you must withhold from the bonus.

Imagine an employee whose annual salary is $12,500, around $1,040 per month. That puts them in the 12% tax band.

One month, you give them a bonus of $500.

You’d have to calculate:

• The regular pay and bonus pay added: 1040 + 500 = 1540
• 12% of that total: 1540 x 12% = 184.80
• 12% of the regular pay: 1040 x 12% = 124.80
• The second value subtracted from the first: 184.80 – 124.80 = 60

So, you’d withhold $60 from that employee’s bonus pay.

If you choose to use the aggregate method, Homebase lets you run this kind of payroll easily:

1. In your Payroll dashboard, click Payroll Runs on the left dashboard.
2. Click the green button near the top of the screen that reads Run Payroll or Resume Payroll.
3. On the page that appears, you’ll see a list of your team members.
4. For each team member, you have the option to click +Add under the Other Earnings column.
5. For each team member you want to add a bonus for, hit +Add and enter the dollar amount in the Bonus box.
6. Hit Save or the Enter key.
7. The bonus amount will show up in the Other Earnings column for each team member.
8. Hit Next, and Homebase will take care of and check all the calculations.

3. Lump the bonus in with regular wages (not recommended).

Technically, there’s a third option. You could increase your employees’ regular wages and not indicate their bonus. This is sometimes called the gross-up method, which means you withhold taxes on combined wages and bonus pay as though they were all regular pay.

This might seem easier, but it could be problematic for your business and staff, so we don’t recommend it.

The IRS usually treats bonuses as “supplemental wages,” so they’re subject to a supplemental withholding rate. So, failing to report your employees’ supplementary pay leads to incorrect tax withholding.

That means extra paperwork and stress for you and your employees when you have to fix the mistake later. Even worse, it may damage your team’s trust in you.

If at any point you think you’ve overpaid bonuses to an employee, notify the employee immediately and work with your payroll to correct the error. For example, ask the staff member to return the overpaid amount or adjust future paychecks to recoup the difference.

State-specific bonus tax rates for 2024

For 2024, state-specific bonus tax rates vary widely across the U.S., with some states applying flat supplemental wage tax rates and others incorporating bonuses into general income tax brackets.

Here’s a summary of the major states:

• California: Bonuses are taxed at a supplemental flat rate of 10.23% for standard supplemental income and a higher rate of 13.3% for stock options and bonuses above $1 million.
• New York: The state taxes bonuses as part of total annual income, with rates ranging from 4% to 10.9%, depending on the income bracket.
• Texas and Florida: No state income tax, so bonuses are only subject to federal withholding and FICA taxes.
• Illinois: A flat state income tax rate of 4.95% applies to all income, including bonuses.
• Georgia: The state applies a progressive income tax rate to bonuses, ranging from 1% to 5.75%.
• Connecticut: For supplemental wages such as bonuses, the flat withholding rate is 6.99%.

Other states, such as Wyoming and Nevada, do not impose state income taxes, which makes them favorable for higher net bonuses.

Five bonus pay best practices

Bonus payroll needs careful planning and good communication to ensure employees understand what they’re entitled to and what they’re not. Otherwise, you could face problems with employees not understanding their bonus pay rates. 

Here are a few bonus pay best practices to follow in your small business:

1. Review your budget.

Before implementing a bonus pay structure in your small business, make sure you can afford to do so. 

Analyze your business budget to confirm that you can sustain a bonus pay scheme without impacting other business operations. Think long-term, as revocation of a bonus pay system will frustrate employees and negatively impact your business. 

2. Tie bonuses to goals.

Tie employee bonuses to clear goals to make them feel obtainable and motivating. For example, a sales team member might earn a bonus for hitting a certain target, or a customer service representative might earn bonus pay by receiving positive customer feedback. 

Make sure your bonus pay goals align with your business strategy. For example, to improve sales, structure bonuses around hitting specific revenue milestones. Or, if you want to improve employee retention, design bonuses that reward tenure or milestones.

3. Plan for taxes.

Bonus pay is subject to federal, state, and payroll taxes. We outlined the three main methods above (percentage, aggregate, and lump-in) and recommend using specific small business payroll software to help you remain compliant with payroll laws.

If employees need clarification about how taxes on bonus pay are calculated, you could hold a workshop or training session on the topic, which might help reduce the number of bonus pay questions you receive. 

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4. Ensure fairness and transparency.

Bonuses should be a source of happiness for employees, but they can quickly become problematic if not handled carefully.

Above all, prioritize fairness and transparency. 

That means:

• Offer bonuses that are linked to measurable factors like performance, sales targets, or hours worked.
• Calculate bonuses the same way for all employees.
• Be transparent about how you calculate and pay your bonuses.

5. Know how to handle disputes.

It’s important to be prepared for disputes or issues whenever you pay out bonuses. For example, if you discover an employee didn’t qualify for what they received, or someone feels short-changed and wants to challenge you.

Here’s how to avoid and address issues regarding bonus pay:

• State your policy for resolving future possible bonus pay issues in your contracts.
• Check the legal rules or requirements that apply to your business.
• Always explain your thought process and actions clearly and fairly.

For example, you may only be able to request that an employee pay back their bonus (or deduct it from their future paychecks) if that possibility is stated upfront in their contract.

You may also not be able to avoid paying non-discretionary bonuses if they’re stated in an employee contract. 

You can’t dismiss someone to avoid paying bonuses. Doing so may cause the staff member to sue you for wrongful termination.

Legal considerations for bonus pay

Federal and state laws govern bonus payroll, so it’s essential to stay compliant with the rules and regulations to avoid any legal consequences. 

Laws to be aware of:

• FLSA
• Equal Pay Laws
• State Laws
• Contractual obligations (e.g., employment contracts and company policies)

Employer responsibilities

As an employer, you are responsible for running bonus payroll effectively. 

• Create and document clear bonus structures: Outline what employees need to do to achieve a bonus and outline discretionary and nondiscretionary bonuses to avoid legal disputes.
• Review bonus policies: Regularly review bonus policies to ensure they comply with federal and state equal pay laws.
• Stay up to date on state laws: Review state-specific regulations often to make sure you comply with any changes in the law.

Employee rights

Employee rights vary depending on federal and state laws, employment contracts, and company policies. 

As general guidance, employees have the right to:

• Non-discriminatory bonus distribution: Pay your employees fairly without discrimination and ensure that you follow the Equal Pay Act (EPA). 
• Earned bonuses: If you state in a contract or company policy that you will pay a bonus, employees have a right to receive that bonus.
• Transparent bonus information: Employees must have access to documented information outlining the criteria and objectives for receiving a bonus at work.

As an employee, you might wonder what to do if a bonus wasn’t reported and you haven’t received your bonus. If this happens, notify your manager or HR department. 

Remember to keep all related documentation, such as pay stubs or communication about the bonus, to help resolve discrepancies.

Run stress-free bonus payroll with Homebase

Pay bonuses without punishing yourself with hours of manual calculations, stressful tax paperwork, or unhappy employees.

Homebase handles payroll for small businesses, including retail and hospitality. Manage all your payments, calculations, paperwork, and bonus tax rates in minutes. And when you sign up, you can onboard employees, track their time, and run payroll all in one place.

FAQ

How does bonus pay work?

Bonus pay is an additional payment that some employers give their employees. It’s a way to reward exceptional performance, meet specific goals, or show appreciation. Bonus pay can be cash, gift cards, or stock options. The bonus amount can vary depending on individual achievements, company profits, or sales targets.

Some bonuses are discretionary, meaning the employer decides who gets them, while others may be based on specific criteria. Bonus pay is typically given on top of an employee’s regular salary and is subject to taxation according to the applicable laws.

Do employers pay taxes on bonuses?

Yes, employers may pay taxes on bonuses. When employers give bonuses to employees, they’re responsible for withholding the necessary taxes from the bonus amount. This means that employers need to deduct a portion of the bonus as taxes and send it to the government on behalf of the employee.

The jurisdiction's tax laws and regulations determine the specific tax withholding rate. Employers ensure that the required taxes are paid by fulfilling their tax obligations.

Are holiday bonuses taxed?

Yes, holiday bonuses are taxed as they’re considered compensation. However, they’re taxed at a different rate than regular pay, so you need to process them differently.

How are year-end bonuses taxed?

If you include a year-end bonus as part of a standard payroll check, you should treat it the same as regular taxable income. If you choose to include year-end bonuses on separate checks, they’ll be taxed at a flat rate of 22%.

What is the difference between overtime pay and a bonus?

Overtime pay is a nondiscretionary bonus. It’s mandatory to pay, and employees are entitled to it based on the number of overtime hours they clocked in during a workweek. On the other hand, many bonuses are discretionary, meaning they’re optional. They’re offered as an incentive for exceptional employee performance.

Is a bonus better than a pay raise?

From a business perspective, yes, bonuses may be more beneficial than pay raises in some cases. Bonuses are variable, often based on employee performance or specific results. Unlike pay raises, you can reduce them if your budget decreases.

Are there disadvantages to handing out bonus payments?

Yes, there are some disadvantages to giving out bonus payments. Once you’ve introduced bonuses, employees may expect them even if you don’t have the budget. This may lead to lower morale and staff disappointment if you can’t deliver.

Does a W-3 include bonuses?

Yes, a W-3 form includes bonus pay. The W-3 form summarizes all W-2 forms submitted by an employer, including total wages, tips, and other compensation, including bonuses. Ensuring all bonus payments are accurately reported on the W-2 and W-3 forms is important.

Does a W-2 include bonuses?

Yes, a W-2 includes bonuses. Any bonuses you receive are taxable income and will be included in Box 1 of your W-2 form and your regular wages. The taxes withheld from your bonus will also be reflected in the W-2.

What do I do if a bonus wasn't reported?

If a bonus wasn’t reported, you should take immediate action to correct the error. First, verify your payroll records to confirm the mistake. Then, the employee will be issued a corrected W-2 form (known as a W-2c) and submit the corrected information to the IRS. Additionally, the employee should be informed of the corrections and provided with the updated tax forms.

Are relocation bonuses taxed?

Yes, relocation bonuses are subject to taxes. Like other bonuses, they are considered supplemental income and subject to federal income tax, Social Security, Medicare, and other state and local taxes. Employers typically withhold a flat rate of 22% for federal income tax on bonuses, including relocation bonuses.

When are quarterly bonuses paid?

Quarterly bonuses are typically paid at the end of each quarter. This means payments are usually made in March, June, September, and December, depending on your company’s fiscal calendar. However, the payment date may vary based on company policy or specific employee agreements.

What is the difference between bonus pay and commission?

A bonus is an additional payment given to an employee as a reward for achieving specific goals or contributing to the company's success. A bonus is usually paid periodically and is not directly tied to individual sales.

A commission is a payment based directly on the sales or revenue generated by the employee. Commissions are typically earned as a percentage of sales and are paid more frequently, such as monthly or after each sale.

What is an STI bonus?

An STI bonus, or Short-Term Incentive bonus, is a performance-based bonus awarded for achieving specific short-term goals, typically within a fiscal year. STI bonuses reward employees for meeting or exceeding objectives that contribute to the company’s short-term success, such as quarterly or annual targets. These bonuses are often tied to individual, team, or company performance metrics.

Bonus vs. double bonus: What’s the difference?

A bonus is an additional payment given to an employee on top of their regular salary, usually as a reward for meeting performance goals or company success. A double bonus is either twice the usual amount or structured so that the employer covers the taxes, effectively doubling the employee's net bonus.

Are relocation bonuses taxed?

Yes, relocation bonuses are taxed. They are treated as part of your regular income, so they are subject to federal and state income taxes and Social Security and Medicare taxes. The bonus will be included in your W-2 form, and your employer will typically withhold taxes from the payment.

How is bonus pay taxed?

The IRS considers bonus pay supplemental income and is subject to specific withholding rules. The federal flat rate for bonuses under $1 million is 22%, while amounts exceeding $1 million are taxed at 37%. State taxes, Social Security (6.2%), and Medicare (1.45%) also apply. 

Are relocation bonuses taxed differently?

No, relocation bonuses are taxed the same as other supplemental wages. They are subject to federal income tax (usually a 22% flat rate), state income taxes, and FICA taxes (Social Security and Medicare). Unlike reimbursed relocation expenses, which may be excluded from taxable income under certain conditions, relocation bonuses are always taxable.

Can bonuses be included in overtime calculations?

Yes, bonuses can be included in overtime calculations if they are non-discretionary, meaning they’re promised based on performance or company goals. Employers must factor these bonuses into the employee's regular rate of pay, which may increase the overtime rate. 

Discretionary bonuses, such as unexpected holiday gifts, are excluded from overtime calculations.

How do you calculate bonuses for part-time employees?

Bonus calculations for part-time employees depend on company policy. Common methods include prorating the bonus based on hours worked or setting separate performance metrics for part-time roles. For example, if a full-time employee gets a $1,000 bonus, a part-time employee working 50% of the hours would receive $500.

Why should you award work bonuses?

Work bonuses motivate employees, help improve performance, and recognize individuals and teams for their achievements. Bonuses also help attract and retain top talent, boost morale, and align employee efforts with company goals. They create a sense of appreciation, build a positive workplace culture, and encourage employees to contribute fully to their roles and responsibilities.

What is the tax on bonus pay?

The tax on bonus pay at the federal level is typically withheld at a flat rate of 22% for bonuses under $1 million. Additional taxes include state income tax (rates vary) and FICA taxes (6.2% for Social Security and 1.45% for Medicare). Bonuses exceeding $1 million are taxed at a federal rate of 37%.