How to calculate pay raises
Last updated on: December 21, 2021
Pay raises are more than just bumps up in salary. Alongside feedback, they are a more concrete way to show acknowledgment of an employee’s daily efforts. And for obvious reasons, the more preferred means of letting them know you are tracking their progress and supporting them.
Aside from showing you how to calculate the right pay raise, we’ve covered the rules that dictate a proper and fair pay raise. By the end of this article, you’ll have a clearer idea of how you can distribute raises to ensure employee satisfaction.
How do pay raises work?
When, how, and why you should give a raise are commonly asked questions. Because there’s money involved, an employer cannot really leave any room for misinterpretation. There has to be one system that applies to everyone, where exceptions are rare but justified. Unless the rules are clear cut, people can easily become demotivated, feel like there’s favoritism in the office, and start to be distrustful of your objectivity and judgment.
To ensure you have a proper system put in play that ensures everyone is treated (and compensated) fairly, you need to cover a lot of avenues. In the following sections, we’ll answer all of the crucial questions for putting a pay raise system in place.
- How often should you give your employee a pay raise?
- How do I know how much money I should give?
- How do I calculate pay raises?
- When do I give a bonus, and when a pay raise?
- How do I build a solid system?
How to calculate pay raise
The calculations themselves are fairly easy to learn. And there are several different ways to do them, based on your preferences.
How to calculate raises within a pay grade
Every pay grade has smaller milestones (steps) an employee can reach, each of which has a pay raise.
Usually, the calculations for these pay raise jumps are based on the salary midpoint formula.
The salary midpoint is the middle between the minimum and the maximum rate of a pay range.
For example, if your minimum is $34k and the maximum is $40k, the salary midpoint would be:
Salary range minimum + Salary range maximum2= Salary range midpoint
Or in our case:
34,000 + 40,0002= 37,000
This is the middle value the employee will reach at some point in their career. But no pay grade has only the highest, lowest, and the middle rate. There are other rates in between those three rates – the incremental pay raises. And to calculate them, you’ll need the salary differential.
Applying the same formula again will give you those incremental pay raises for each step in between.
Calculating flat rate pay raise
If you are considering paying a yearly flat rate, instead of percentages, here’s what you can do.
Let’s say that you want to give a $2.5k raise to an employee to their annual salary. However, the calculation doesn’t end there. It’s in the company’s and employee’s best interest to see how this increase reflects on a weekly or a monthly level. Using further calculations, you get more detailed data.
You add the raise to the yearly salary.
$40,000 + $2,500 = $42,500
Divide the result by the number of weeks in a given year, which is 52.
$42,500 / 52 = $817,30
Subtract the old weekly wage from the new weekly wage.
$817,30 – $769,23 = $48,07
The increase in pay is $48, 07 per week.
And if you want fewer steps:
Take the desired yearly increase in pay raise, and divide it by the 52 weeks in a year.
$2,500 / 52 = $48,07
Aside from calculating the flat rate, you can also base your calculation on percentile increases.
Calculating pay raise in percentages
Let’s use an example from a previous section, and say that you have a top performer in your company to whom you want to give a 4.6% raise.
Divide your percentile raise to a 100 to get the required decimal value
4.6% / 100 = 0.046
Multiply the percentage increase by the current salary.
$40,000 x 0.046 = $1,840
Add the increase to get the new salary – $41,840.
Divide the new salary with the 52 weeks in a year to see the new weekly salary.
$41,840 / 52 = 804,61
Subtract the old weekly salary from the new weekly salary to see what the raise weekly flat rate is.
$804,61 – $769,23 = $35,38.
This concludes that the 4.6% raise on an employee’s $40,000 yearly salary is $35,38 per week.
Converting flat-rate pay raise to a percentile
In the case where you want to see your flat rate raise is in percentages, there is an easy formula.
New salary – Old salaryOld salary x 100 = Raise percentage
Applying this to our example above, we get:
41,840 – 40,00040,000x 100 = 4.6
But simply calculating pay raise isn’t enough. It’s important to have a firm framework in place, where you know exactly when, and to whom you give pay raises.
When should you give a raise?
There is no universal, legally binding timeframe for a raise. As you will see here and later as we move on, a lot of the decisions come down to the employer (or company CEO and the CFO) – whether they want to list it as a rule in the contracts, have a merit system, include them in annual performance reviews, etc.
However, across all industries, we can single out several different types of pay raises, and the conditions they require.
Regular raises based on time spent in the company
Some businesses offer a steady raise, and it can come annually or bi-annually. They are given regardless of the employee’s performance.
High-performing workers and those lagging behind get equal raises, and there are rarely any other requirements than working for the company for a specific amount of time. They’re the easiest to implement, as they release you of any responsibility of tracking workflow. As such, they’re rarely seen in the private sector – the company would more likely lose money. Additionally, these kinds of raises actually demotivate people. If everyone gets equal pay raise, then there is no need for anyone to stand out, since they won’t be rewarded.
For a similar reason, the public sector (or the government) actually uses this method. Because they annually raise the cost of living arrangements such as utility bills, taxes, and produce prices, they’re required to match the salaries, too. Some examples of public employees include teachers, doctors, police officers, sanitation workers (janitors, cleaners, etc). In their cases, these employees can earn much less than their counterparts in the private sector, and so an annual or bi-annual pay raise of around 2.5% makes more sense.
It’s important to note that the percentage of these pay raises depends on the COLA (cost of living arrangements) determined by the government.
Raises based on market demand and internal value
Every employee has a market price, or how much they’re worth in the job market in their industry, and an internal value, or how much they contribute to the company. Let’s see how this reflects on an employer’s pay raise practices.
- When the market demand for an employee’s skill set goes up, you will want to oversee the changes outside, as the price for those employees will go up. Just like in the economy, there’s always supply and demand. If there aren’t enough experts in a certain field, they’ll be valued much more. In that case, a raise would be necessary to prevent the person from transferring.
- When an employee has been in your company for a substantial number of years, and their data shows they’ve been of great value to the company, they should be rewarded accordingly. A designer with five years of experience is worth more than the one with three.
- An employee’s internal value to the company can change significantly. When one starts to take on more demanding projects that require employees to step up, their job description will change to some extent. If you notice that such projects are bound to continue, and the employees can manage it, then a pay raise is more than logical. However, if the project was a one-time thing, then a large bonus will be better for the company finances than a permanent pay raise.
Raises based on pay grade
Pay grade represents the range between the starting salary one is paid for their job position, and the highest salary they can receive in that position. So, a person can start a job for $36k and earn up to $40k within a few years. To get a salary over that, they would need to move up in the hierarchy. Every pay grade has a set of steps or milestones that needs to be crossed, in order to gradually increase an employee’s salary to the maximum for their pay grade.
How do pay grade raises work?
The steps within a pay grade award raises are based on:
- The length of the person’s employment in that position;
- The experience brought in and gained during their employment;
The raises between pay grades are affected by:
- The level of responsibility the position brings;
- The level of management over others.
For example, an art designer starting at a company will be working on illustrations and website layout based on the input and instructions from supervisors. After some time, they gain more autonomy, and need little consultation, at the same time providing excellent results.
This awards the designer pay raises within their pay grade as a junior designer.
Later, they are assigned to be a supervisor to a new designer and help with their tasks.
The designer moves to a new pay grade, and along with new steps in experience and time worked, they earn raises.
Ultimately, they can become the chief supervisor for an entire design team, earning the top of the pay grade for their position as a designer. They no longer work on the website layout and logos, for example, but make creative decisions and delegate tasks to others. Their concerns are now big-picture and work on larger projects.
The designer moves to the highest pay grade possible for that particular job position.
A higher pay grade than their current top salary would require a change of position or company.
Why do some pay raises overlap between pay grades?
You may have noticed in the table above, that some salaries overlap. For example, a $36k salary on the high end of pay grade 1 is seen on the lower end of pay grade 2.
This is because not all employees will start their job at a company at grade 1. This is normally reserved for industry beginners or employees fresh out of college. If a more experienced candidate applies, they can start at grade 2 or even 3.
On top of that, this kind of pay range allows for more flexibility. It lets employees receive financial benefits without necessarily having to accept promotions and responsibilities they’re not ready for. Not to mention that, for the CFO, this is the most financially-friendly option for the company budget.
How many pay grades should I have?
This is entirely optional and, as mentioned before, depends on the industry and company itself.
For example, the federal government has 15 pay grades. Larger companies can have between 10-15, and small ones may not need more than five for each department.
The one thing to keep in mind is that the pay grade number needs to reflect your structure and work in favor of both the company and the employees.
While determining the percentage is completely up to you, around 2,5% or 3% yearly seem to be universally accepted. However, keep in mind that the raise is also reflective of what you wish to achieve with it. Because if you want to keep an employee that considers transferring to a new company, you will offer them a larger raise than their peers, for example.
Raises based on performance or merit
With annual or bi-annual reviews, you can give timely feedback to employees, and give a pay raise as a reward to high-performing employees. This is a more demanding method for supervisors, but the most motivating one for employees. Good work gets recognized and further incentivized. You increase the chances of retaining productive workers who provide a stream of great results.
Merit raises can be given across all departments. The main difference from regular raises is that they don’t have a set time when they’re given. Merit raises are tied to specific goals, whether with the employee’s career development (new skills learned, improved numbers and data) or with the projects the employees are involved with.
To be able to give raises based on merit you need:
- A roadmap of your projects, goals, and deadlines;
- An understanding between you and the employees of what achievements will grant them a merit increase; (clearly communicate the goals you’ve set!)
- Detailed data on employee performance, results, and ROI;
- Available funds for a merit increase.
When you can objectively look at your employee’s performance, it becomes easier to determine who gets a pay raise based on how much they benefit the company. Had everyone gotten a 2% raise instead of just one or two people, the company would have lost significant amounts of money.
Additionally, with this merit-based system, you avoid any doubts about favoritism. But keep in mind that doing detailed data tracking for every employee can put a strain on manpower and resources. For this reason, some businesses opt out of this method.
What is a good pay raise?
First of all, “a good pay raise” depends on the country you live in, the industry standard, and most importantly, the company itself. The size of the business, your current financial state, the market demand, clients… it all plays into the amount of money at your disposal for pay raises. And that is why the percentage of the raise depends on the employer.
However, there is a “guideline” of sorts that some companies go by. Employers have the possibility to look at projections and expected nation-wide pay raises. For the year 2020, it looks like this:
Low-performing workers can expect a pay raise of 1% or less (which seems to be a continuing trend from the past years).
High-performing workers can expect as much as a 4.6% pay raise (less from the predicted 5% last year).
The average pay raise remains the standard 2.7% – 3%.
To emphasize, these are simply projections based on the labor market, collective budget, and more. These can be great reference points, which you further adjust based on your own financial standing.
How to build a solid pay raise system
To be able to give fair raises in a timely manner, but also keep your finances in check, you need a framework to rely on. Something to consult to ensure objectivity and avoid guesstimating.
A good, objective and fair pay raise system depends on:
- Available funds;
- Company size and employee number;
- Geographical location;
- The industry you’re in and competitiveness of the market;
- The internal structure implemented for career growth.
Make yearly plans and revise them
Your pay raises should be included in the budgeting plans for the year. Of course, each year is different, and when some are more successful than others, it will reflect on employees’ finances as well.
Layoffs, pay cuts, and market disruptions are very real, and they can all affect how you distribute the budget. That is why you must revise and adapt your plan once or twice a year to reflect those changes.
Be transparent about the pay grade range and raises
Employees should know what their roadmap to a new pay grade looks like. Many companies seem to shy away from these pieces of information like they’re trade secrets.
But if you want to nurture transparency and motivate your employees to work as hard as they can, they should be aware of what it takes to reach that next milestone. Let them know how long they need to work here for that next pay raise, if they need new skills or responsibilities, etc.
Note: Check if a pay raise is going to change the status of an employee when it comes to overtime. If this move is going to make them exempt from overtime pay, it’s your legal obligation to inform them.
More information on compensatory time and who is exempt and non-exempt from overtime pay:
Pay equity is a MUST
Pay equity is a way to ensure that everyone gets paid fairly, regardless of their race, gender, or ability. It’s there to show there is no discrimination in employee treatment. Almost all of the states have revised their federal laws on pay equity and are implementing a more fair system.
Some of these new practices include:
- Difference in pay reflects the difference in experience (or lack thereof), such as education or professional skill;
- Employers no longer ask about a candidate’s salary history;
- Comparing workers to their peers in a larger area, not just a specific location (but still no larger than a county);
- Pay transparency – open discussion on salaries no longer a taboo.
Pay raise calculation comes easy. It’s when and how you decide to distribute those raises while maintaining pay equity is what’s difficult and needs to be established beforehand. By following a budgeting roadmap, you can know every year how much you can set aside for raises, and with a proper data tracker, and performance reviews, you can decide who gets them. With so many different industries and their constant fluctuations, it becomes impossible to consider a universal standard for pay raises, which is why plenty of companies decide on frameworks that reflect the job market and their industry’s standard.