Retroactive pay, commonly referred to as retro pay, is the compensation owed to an employee (from an employer) due to a shortfall in payment during the previous pay period.
Sometimes confused with back pay, retro pay makes up the difference between the wages that an employee should have been paid and what they were actually paid. Retro pay corrects payroll mistakes such as forgotten raises or miscalculations on overtime pay.
Back pay refers to missed wages, such as unpaid wages, missed overtime pay, commissions, and missed hours.
How is retro pay calculated?
When calculating the shortfall, employers must subtract the amount paid to the employee from the amount that should have been paid.
Both hourly employees and salaried employees qualify for retro payment, and the calculation differs slightly for both depending on their regular pay rate.
Consider the following example as a guideline on how to pay retro pay for employees that receive hourly pay.
An employee receives $15 per hour on a weekly basis, with an overtime pay of $22.50 per hour. During one week, the employee works 48 hours, of which eight hours is overtime, but paid the wrong rate of $15 per hour for the extra hours.
- Determine the gross wages paid in the week ($15 x 48 hours = $720)
- Calculate the overtime rate for overtime hours ($22.50 x 8 hours = $180)
- Determine the correct amount of money owed to the employee ($15 x 40 + $180 = $780)
- Subtract the amount of money paid to the employee from the amount that they should have received ($780 - $720 = $60 retro pay)
Before calculating retro pay for a salaried employee, you need to know the difference in their old and new salary, as well as the effective date for the salary change and the number of pay periods.
Consider the following example. An employee earns $40,000 per year, paid biweekly (26 pay periods). The employee receives a $5,000 raise, bringing their salary to $45,000, yet the pay raise is forgotten in the new pay period.
- Calculate the employee’s gross pay per period before the raise
- ($40,000 / 26 = $1,538.46)
- Calculate the employee’s gross pay period after the raise
- ($45,000 / 26 = $1,730)
- Calculate retro pay by subtracting the amount paid from the amount that should be paid
- ($1,730 - $1,538.46 = $191.54)
Retro pay is taxable
Tax withholding is applied to the gross payment after calculated. Before an employee receives retro payment, employers must apply employment and payroll taxes.
For example, consider social security and Medicare taxes (FICA), federal income tax, as well as state and local income tax.
Examples of retroactive pay
Common payroll errors that impact retroactive pay include;
- Failing to include the overtime rate
- Miscalculations due to shift differentials where an employer fails to pay an increased rate
- Delay in paying commissions
- Forgetting to pay the new rate after an employee receives an increase
Supplemental wages may include bonuses, miscellaneous income, and cashed-out vacation. All of this income should be considered for retroactive pay.
A union collective agreement includes a provision that workers are entitled to retroactive pay, and should highlight how far back these retroactive claims can go.
Retroactive pay can also be court-ordered in the instance of an employer going to court for the following reasons;
- Breach of contract
- Minimum wage violations that contradict the Fair Labor Standards Act (FLSA)
How to issue retro pay
There are several ways to make retroactive payment. Whether a big or small business, the following steps should be considered;
- Communicate with the employee
- Work quickly to amend the error
- Use payroll system to adjust the employee’s next paycheck
- Confirm compliance with local and federal labor laws
- Ensure that the compensation is applied in the next payroll run (and reflected on the pay stub)