Compensation Fundamentals: Building Blocks

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.

A comprehensive compensation system can be broken down into its component parts. These parts include the building blocks and system design elements.

This guide discusses the key building blocks of an employee compensation system. It should be reviewed together with the other parts of the Compensation Fundamentals series:

Compensation System Building Blocks

Compensation building blocks are the foundation for establishing compensation systems. HR places building blocks within a total compensation framework.

Building blocks include base pay and adjustments to base pay according to cost-of-living increases, seniority, job performance or the acquisition of new competencies, skills or knowledge sets. Base pay refers to recurring hourly pay or the annual salary employees receive for performing their jobs.

Total Compensation

Base pay (also known as core compensation) and employee benefits make up total compensation. Employee benefits refer to compensation other than wages or salary. Paid vacation and medical insurance are examples of employee benefits.

Base Pay (Core Compensation)

Organizations distribute base pay to employees either as hourly pay (wages) or as annual salary. Employees earn hourly pay for each hour worked. Salaried employees earn pay for performing their jobs, regardless of the number of hours worked throughout the year. Organizations calculate salary on an annual basis. The federal Fair Labor Standards Act (FLSA) and state wage and hour laws created criteria for deciding whether employees should be paid hourly or by salary.

Adjustments to Base Pay

HR uses one or more of the following methods for adjusting base pay over time:

Cost-of-Living Adjustments

Cost-of-living adjustments are fixed increases to base pay based on annual increases in the cost of living. Oftentimes, the US Bureau of Labor Statistics (BLS) Consumer Price Index (CPI) is the basis for awarding cost-of-living increases because it is a comprehensive measure of the changes in the costs of goods and services based on the typical consumer market basket - including food, health care and housing - both nationwide and for smaller geographic areas. The goal of cost-of-living increases is to maintain the purchasing power of earnings that is eroded over time as the costs of goods and services increase. The following information further defines the CPI and the necessity of understanding how to calculate changes in cost of living over time.

About the CPI and Calculating Changes in the Cost of Living

The CPI indexes monthly price changes of goods and services that people buy for day-to-day living. The index is based on a representative sample of goods and services. The BLS gathers price information from thousands of retail and service establishments. Thousands of landlords provide information about rental costs, and thousands of homeowners give cost information pertaining to home ownership.

Indexes are available for two population groups: a CPI for All Urban Consumers (CPI-U), which covers approximately 93 percent of the total population, and a CPI for Urban Wage Earners and Clerical Workers (CPI-W), which covers 29 percent of the population. Most commonly, cost-of-living reports are based on the more comprehensive CPI-U.

The CPI represents the average of the price changes for the representative sample of goods and services within each of the following areas:

  • Urban United States
  • Four geographic regions (sometimes called Census regions): Northeast, Midwest, South, and West
  • Three population-size classes: large metropolitan areas, small metropolitan areas, and non-metropolitan urban places
  • Select region-size classes - regions cross-classified by population size (for example, large metropolitan areas in the Northeast)
  • Select metropolitan areas (e.g., St. Louis, MO-IL)

Calculating Changes in the Cost of Living

The CPI represents index numbers (for example, 243.21) for a specific location at a designated point in time. As a result, a single index number does not provide any practical meaning; however, comparing two index numbers from within the same location allows us to calculate the change in cost-of-living over the chosen period. For example:

CPI, United States, July Year X (prior period): 258.604

CPI, United States, July Year Y (current period): 272.265

The percent change in the cost of living is based on the following formula:

(Current CPI − Prior CPI) ÷ Prior CPI

= [(272.265 − 258.604) ÷ 258.604]

= [13.661 ÷ 258.604]

= .05282 (i.e., 5.282%)

Based on this calculation, the US cost of living increased 5.282% between Year X and Year Y. Results can be either positive or negative. A positive number means that the cost of living has increased. A negative number means that the cost of living has decreased.

Only CPI numbers from within the same location may be compared. It is not possible to compare CPI numbers between different locations. For instance, the CPI in Year X is 265.232 in the Los Angeles Metro Area and for the same period, the CPI for the New York Metro Area is 269.852. Comparing these two index numbers does not have any meaning because they are derived from two different locations.

Seniority Criteria

Seniority pay increases are fixed increases to hourly pay and annual salaries based on length of service to an organization. This base pay adjustment is established on the idea that employees' value increases as they become more skilled and proficient in performing their jobs. This method for raising pay does not include a measurement of job performance. Seniority pay practices are most prevalent in unionized settings and the public sector, including local, state and federal governments.

Merit Criteria

Merit pay increases reward employees based on past performance. Supervisors and managers use subjective performance appraisal tools to evaluate employee job performance, typically on an annual basis. Merit increases are commonly used for increasing pay in the private sector and are typically granted as a percentage of current base pay. Reliable and valid performance appraisals are an essential feature of merit pay programs.

Incentives Criteria

Incentive pay compensates employees for achieving, in whole or in part, a predetermined job performance objective. Unlike cost-of-living adjustments, seniority pay and merit pay, incentive rewards are awarded as one-time additions on top of base pay. Incentive pay is based on a pre-established formula, individual goals, group goals (department-wide productivity) or organization profitability (profit-sharing plans). Incentive pay measures of job performance are objective, which further distinguishes incentive pay from merit pay.

(Note: When an employer contracts, agrees or makes a promise to pay a nondiscretionary bonus - such as when an employee successfully makes a quote - the bonus must be included in the regular rate of pay when calculating overtime.)

Management by objectives (MBO) plans are an example of an incentive plan pertaining to individual accomplishments. The plan pays employees when they meet or exceed objectives based on sales, profit, production or other measures.

Practical Example

An employee is responsible for preparing the organization's annual affirmative action plan and submitting it to the Office of Federal Contract Compliance Programs (OFCCP) for review by the specified deadline and OFCCP approval. Assume that the deadline for submission is June 1.

The employee will earn incentive pay based on the highest level of achieved successful performance:

$500: Completion of the statistical analyses and narrative before June 15 (but not yet submitted to the OFCCP); otherwise, no incentive earned.

$750: Full plan submission after June 1 but before June 15, and subsequent OFCCP approval.

$2,000: Full plan submission by June 1 and subsequent OFCCP approval.

Although the goal is to submit the plan by the deadline and to receive subsequent OFCCP approval, completion of the previous substantial tasks constitutes foundation work for the affirmative action plan, warranting a lesser award.

Person-Focused Criteria

Person-focused pay rewards employees for acquiring certain knowledge, skills or competencies. Competencies refer to an individual's capacity to orchestrate and apply combinations of knowledge and skills consistently over time to perform work successfully. Customer orientation is an example of a competency and may be defined as a combination of product knowledge and customer expectations and active listening and interpersonal skills. Like merit pay, person-focused pay increases the focus on individuals, and pay awards are fixed increases to base pay. Unlike merit pay, which focuses on performance attained, person-focused pay rewards employees on their potential for demonstrating excellent job performance based on learning new knowledge, skills or competencies.

Although less common than seniority or pay-for-performance reward systems, person-focused pay programs are increasingly more important. For instance, technology is changing how organizations make products. Advanced robotics and the use of artificial intelligence have eliminated many of the simple tasks once performed by employees. Still, the use of these complex systems requires oversight and the ability to troubleshoot to ensure that the systems are performing to specification - competencies that a person-focused pay program can help to grow.

Additional Resources

Compensation Fundamentals: System Design Elements

Compensation Fundamentals: Common Pay Structures

Compensation Fundamentals: Legal Considerations and Assessing Effectiveness

Compensation Philosophy

Manage Effective Employee Compensation Systems Checklist

How to Develop a Compensation Strategy

How to Use the Point Method of Job Evaluation