Compensation Fundamentals: Legal Considerations and Assessing Effectiveness

Author: Joseph J. Martocchio, Professor Emeritus, University of Illinois at Urbana-Champaign


Employee compensation encompasses the rewards employees receive for performing their jobs, to adjust for cost-of-living increases, for their seniority, job performance over time, or acquiring new competencies, skills or knowledge sets.

HR professionals collaborate with high-level managers to determine the optimal compensation plans that will facilitate recruitment, employee job performance and retention - all within budgetary limits. Then, HR relies on its expertise to create and oversee the implementation of compensation programs.

This guide discusses key legal considerations an employer must consider when designing a compensation program and metrics an employer can use to make sure its compensation system is meeting its goals. It should be reviewed together with the other parts of the Compensation Fundamentals series:

HR professionals and others make decisions within the scope of pertinent employment laws to maintain compliance with government mandates. Compliance helps to protect the wellbeing of employees and promotes the financial and reputational interests of an organization's owners or shareholders.

Below is a summary of the main laws pertinent to compensation practice:

Fair Labor Standards Act

Two major provisions of the federal Fair Labor Standards Act (FLSA) apply. First, the overtime pay provision created criteria for deciding whether employees should be paid hourly or by salary. Specifically, employees who receive pay on an hourly basis generally are not exempt from the overtime pay provision while employees who receive pay on an annual salaried basis are generally exempt from the overtime pay provision.

The FLSA addresses the issue of overtime pay for employees whose weekly schedule is fixed and for employees whose work hours vary by week. An employee's workweek is a fixed and regularly recurring period of 168 hours - seven consecutive 24-hour periods. Nonexempt employees paid on an hourly basis receive overtime pay equal to at least 1.5 the normal hourly pay rate for each hour worked above 40 hours in a workweek.

The FLSA also addresses the computation of overtime pay for salaried nonexempt employees whose weekly work hours vary. Payments as well as the fixed salary are well-suited to the use of the fluctuating workweek method of compensation. Employers must include those additional payments in the calculation of the regular pay rate.

The second FLSA provision established the federal hourly minimum wage rate. Since the passage of the FLSA, many states and localities have established laws that set the hourly minimum wage rate higher than the federal level.

Equal Pay Act

The Equal Pay Act is based on the principle that men and women should receive equal pay for performing equal work, with the following general exceptions: seniority, merit, a system that measures earnings by quantity or quality of production, or a differential based on any factor other than sex.

Title VII of the Civil Rights Act of 1964

Title VII of the Civil Rights Act of 1964 affirms that it is unlawful for an employer to discriminate against any individual with respect to his compensation, terms, conditions or privileges of employment, because of such individual's race, color, religion, sex, or national origin.

Pregnancy Discrimination Act

The Pregnancy Discrimination Act, enacted in 1978, amended Title VII of the Civil Rights Act of 1964 to prohibit sex discrimination in employment because of pregnancy, childbirth or related medical conditions.

Age Discrimination in Employment Act

The Age Discrimination in Employment Act prohibits discrimination in employment, including compensation, for employees who are aged 40 or older.

Americans with Disabilities Act

The Americans with Disabilities Act (ADA) prohibits discrimination against qualified individuals with disabilities in several areas, including employment practices. Title I of the ADA protects the rights of both employees and job seekers.

Assessing the Effectiveness of Compensation Systems

If properly developed and implemented, compensation systems will help the employer attract top talent in the labor market, keep its current employees engaged and reduce employee turnover. Compensation and HR professionals should have metrics in place to make sure the employer's compensation system is functioning to meet the goals.

Metrics such as the following should be followed:

Talent Acquisition

The extent to which the employer can fill open positions internally versus the time and direct cost of recruiting externally is often a revealing sign about compensation program effectiveness. When organizations find it difficult to fill positions from within, they may work with HR professionals to create an employee referral program that will incentivize employees to recommend job candidates for employment.

Job-Acceptance Rates

If candidates reject offers of employment, determine whether the organization's compensation is competitive. It is also important to consider whether there are non-compensation factors that lead to low job acceptance rates. These factors include the lack of job growth opportunities or the unavailability of setting flexible work schedules.

Employee Retention

Ascertain whether the employer is lowering dysfunctional turnover. Dysfunctional turnover refers to voluntary quitting among high performing employees. High performers may choose to leave an organization because of hourly pay or annual salary stagnation compared to what competing organizations offer. They may also consider leaving when the organization does not support career advancement, which also has the consequence of stagnant pay. The primary solution is increasing the pay budget to provide merit pay increases. However, when permanent budget increases are not feasible, HR professionals should develop a plan to award regular bonuses (pay not made as a fixed addition to base pay) for employees with compressed pay until merit pay adjustments can be made.


Engaged employees perform their jobs efficiently and effectively when they receive the support of managers and supervisors who facilitate work. Employees are often more productive when they judge their pay as fair and they receive frequent merit or incentive pay awards to reinforce their accomplishments.

Compensation Budget

Grow compensation budgets as possible to facilitate competitive pay and job performance-based rewards. When expected or earned organization profits fall below desired targets, leadership is less likely to increase the compensation budget. HR professionals should identify wherever possible current budgetary resources that are not leading to expected outcomes. For instance, they may terminate underutilized benefits and divert those resources to boost the wage/salary budget.

Additional Resources

Compensation Fundamentals: Building Blocks

Compensation Fundamentals: System Design Elements

Compensation Fundamentals: Common Pay Structures

Compensation Philosophy

Manage Effective Employee Compensation Systems Checklist

How to Develop a Compensation Strategy

How to Use the Point Method of Job Evaluation