What is Retro Pay and How Does it Work?

Everyone understands that payroll errors can happen. But compensation shortfalls that go unaddressed for too long? They’re a quick road to high turnover and low morale. That’s why a big part of keeping your hourly employees satisfied—not to mention keeping your company on the right side of labor laws—is calculating retro pay, aka retroactive pay, and sending it out as quickly as possible. Not sure what counts as retro pay, how to calculate it, the difference between retro pay and back pay, or whether it's taxed differently? Read on as we answer these questions and go through an example for hourly workers. We’ll also share one great app that’ll make the payroll process a lot easier and a lot more accurate, saving you major payroll headaches.

What is retro pay?

Retro pay (short for retroactive pay) is when an amount is paid to an employee to make up for a shortfall in a previous pay cycle due to an error. The amount should be the difference between what they should have received and what is paid to them in their next pay cycle.

How does retroactive pay work?

As per the Fair Labor Standards Act (FLSA), employers need to issue a retro payment as part of the next pay cycle (usually as miscellaneous income) no later than 12 days after a pay period ends. However, if including it in a regular paycheck means you’re issuing it after this 12-day period, then you would need to issue retro pay through a separate paycheck instead.

When is retro pay needed?

Common payroll-related mistakes leading to retro pay include:

• Overtime: Your employee worked overtime, but you accidentally paid them their regular rate rather than their overtime rate.
• Raises: Your employee received a raise, but it was not reflected in their pay. Or, you added a raise to their paycheck, but you didn't provide the promised amount.
• Shift differentials: Your employee should have been paid an increased rate for hours worked outside of their normal shift (like Christmas Day or a night shift), but they were accidentally paid their regular rate.
• Commissions: Your employee was owed a commission, but the funds were delayed due to late customer payment. (This is considered retro pay in some accounting systems.)

Sometimes (unfortunately), retro pay can also be owed as a result of an employee winning a legal proceeding against your business. 

What's the difference between retro pay and back pay?

Whereas retro pay compensates an employee for an error in their pay, back pay is compensation that makes up for a pay period where an employee (gulp) wasn’t paid at all. In other words, one refers to incorrect salary, while the other refers to missing salary.Instances where back pay is owed could include:

• when an employee wasn’t compensated at all for working overtime
• when a commission or bonus wasn’t paid 
• when your company was unable to pay or had an issue with the payment system

Back payments are usually higher than retro payments. That's because back pay is a failure to distribute the total compensation vs. just an error in calculating it. Back pay is also easier to calculate since it doesn't require as many manual calculations.

How does retroactive pay affect taxes?

Although it’s a correction to a past paycheck, any retroactive payment must be taxed. Retro pay is subject to the same payroll taxes that you usually account for according to the employee’s contract.If you adjust the employee’s pay for federal income tax, state income tax, local income tax, Social Security payments, and Medicare/Medicaid through their payroll, then you must make the same adjustments to the retro pay.

How to calculate retro pay

To determine how much retro pay is owed to your hourly employee, go through the following steps: 

1. Calculate the difference between the pay they received and the pay they should have receivedIf retro pay is necessary because of a raise, confirm the number of pay periods with incorrect paychecks by tracking when the raise began. Calculate the difference between the incorrect rate and the correct rate you should have paid per paycheck. Multiply this difference by the number of incorrect paychecks, and you'll know what your employee is owed. If it's for overtime pay or shift differentials, check the employee’s sign-out times or shift schedule to determine how many incorrectly compensated hours they worked (going back and tallying across multiple pay periods if necessary). Calculate the difference between the correct and incorrect rate that was paid for these irregular hours, and you've got your number.  

2. Withhold the right amount of taxesAt this point you need to withhold the correct amount of taxes from the gross retro pay. If the employee has other withholdings in their regular paychecks, like insurance policy deductions or retirement deductions, then withhold those amounts, too.

3. Pay your employeeNow that you've done the math, go ahead and send that money!

An example of how to calculate retro pay

Now let’s take the case of a specific hourly employee.Mia earns $15 per hour as an hourly worker. In the last week, Mia worked a total of 50 hours (10 hours of overtime). However, due to a payroll mistake, you accidentally paid her $12 per hour for overtime wages instead of time-and-a-half.Start by asking, what gross wages were incorrectly paid to Mia without giving her time-and-a-half for overtime? They were: $12 x 50 hours = $600. Then look at how much you should have paid her. Mia should have made:$12 x 40 hours = $480 for her regular hours, plus $18 (time-and-a-half) x 10 hours = $180 for her overtime hours.Add $480 for her regular hours to $180 for her overtime hours. Her correct rate should have been $660.You can see that you now owe Mia $60 in gross retro pay.

How to avoid payroll mistakes

If your small business doesn’t have dedicated HR, frequent payroll errors will inevitably lead to instances of retro pay. But avoiding payroll mistakes becomes so much easier when you’re using payroll software like Homebase. Designed especially for small businesses without dedicated HR or payroll, Homebase helps make your payroll process smoother, more efficient, and far less error-prone. 

By keeping all your data in one place, hours worked are instantly calculated. Breaks and overtime are tracked. And it’s all synced to payroll, so mistakes are easily avoided. No more stress from missed errors, tax, health insurance, and other deductions.Is your business struggling with payroll errors and dealing with a lot of retro pay? Homebase’s suite of time tracking, timesheet, and payroll tools gives you everything you need to run easier, more accurate payroll in a few clicks. Get started with Homebase today.