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Discretionary Bonus: What It Is, Why It Fails, and Better Options

By:
Ryan Shank

As an employer, you're likely interested in ways you can further incentivize your employees outside generic practices like overtime pay. You want to give them even more reasons to work hard and invest in the success of your business.

This may have made you consider a discretionary bonus.

While there can be minor upsides in certain circumstances, this method has many serious flaws - especially when it's compared to profit sharing plans.

In this guide, we'll tell you exactly what a discretionary bonus is, how it works, and more.

However, we'll mainly be showing you why it's probably not the best option for you and your employees.

What Is A Discretionary Bonus?

Discretionary bonuses are a type of bonus payment awarded to an employee at their employer's discretion. This means that there is no predetermined contract or plan in place for the bonus to be paid.

Generally, a discretionary bonus is awarded for things like completing challenging tasks, exceptional performance, and overachieving on targets.

Unlike other types of bonuses like referral bonuses, safety bonuses, and attendance bonuses, discretionary bonuses can be paid in any amount and at any time.

The reason employers sometimes pay bonuses in this way is because they believe it will boost morale, motivate their teams, and recognize their contributions. Yet, there are many downsides to such bonuses which we'll cover in detail later.

Discretionary vs non-discretionary bonus: What's the difference?

As mentioned, discretionary bonuses are in no way predetermined by a plan or contract. So, the timing of the payment and the amount of bonus money can be highly variable.

Non-discretionary bonuses, on the other hand, are predetermined payments employees know they'll receive if certain conditions are met.

Non-discretionary bonus plans are designed to incentivize employees to meet specific targets and provide them with achievable goals that must be reached for the bonus payments to be triggered.

How Discretionary Bonuses Work

Now you know what discretionary bonuses are and how they compare to non-discretionary bonuses - but how do they actually work?

Let's take a look at their impact on taxes and some of their key features to find out.

Discretionary bonus's impact on taxes

In the U.S., discretionary bonuses are considered supplemental income. They're taxed using either the aggregate or percentage method.

  • Aggregate method: The bonus is included in the regular paycheck of the employee and this total amount is taxed.
  • Percentage method: Any discretionary bonus up to $1 million is taxed at 22% and any bonuses over $1 million are taxed at 37%.

For the employee, the aggregate method can lead to a higher tax withholding than necessary. This could result in a lower take-home amount or tax refund.

For employers, discretionary bonuses offer some flexibility when it comes to tax planning. Since employers can choose the timing and amounts involved in the bonus program, they have some control over how it will affect the tax implications for both the employees and the employer.

Often, for tax purposes, a non-discretionary bonus is excluded from an employee's regular rate of pay which can be advantageous for tax planning.

Key features of discretionary bonuses

Flexibility in awarding

Discretionary bonuses are flexible because they're paid at the sole discretion of the employer. This allows them to consider factors like company performance, budgetary constraints, and employee performance before deciding to award bonuses.

So, if an employer determines that the circumstances aren't right for the company to pay a bonus, they can choose not to.

An employer doesn't have this flexibility when it comes to non-discretionary bonuses. Regardless of the company's situation, they're contractually obliged to pay out these bonuses when the predetermined conditions are met.

Criteria and decision-making

The criteria for discretionary bonuses are not known by employees and are fully determined by the employer.

The criteria may be agreed upon by the management team and the bonuses paid when they're met. Or, there may not be any specific criteria, and the bonuses will be paid to employees who are performing well.

It's also up to the employer to calculate discretionary bonuses and decide on the bonus amount. The methods used to calculate discretionary bonuses vary greatly between organizations.

These decisions rest with the employer, and the bonus will always come as a surprise to the employee.

Impact on employee morale

Compared to things like overtime pay, the unpredictability of discretionary bonuses can create employee uncertainty.

The fact they don't know if and when they'll receive a bonus can cause them to lose motivation and feel as if they won't be rewarded for their hard work.

Why Discretionary Bonuses DON'T Work

We've already touched on why discretionary bonuses can be a poor additional compensation plan for employees. Now, we'll dive into exactly why this type of bonus simply doesn't work.

Lack of transparency and consistency

The lack of transparency and consistency regarding the discretionary bonus model can lead to:

  • Employees feel unable to challenge decisions they perceive as unfair which can make them feel powerless and voiceless. This can lower morale and decrease engagement.
  • Employees are likely to compare their bonus amounts which can lead to discontentment as they're unaware how the amounts were decided upon.
  • Employees struggle to learn and improve when they don't understand the rationale behind bonus decisions.
  • There may be perceptions of favoritism where employees believe an employer is rewarding certain groups or individuals based on factors unrelated to performance.

Potential for reduced motivation

One of the biggest downsides of the discretionary bonus is its ability to severely demotivate employees. It can do this in several ways, including:

  • The unpredictability of getting a bonus, and how much it'll be, can stifle effort as employees may feel their efforts are futile.
  • If employees feel the bonuses are being awarded based on favoritism, they may feel like they have no incentive to try harder as they suspect they'll never be given a bonus anyway.
  • As employees are unaware of the criteria for the bonuses, they may choose to focus on whatever tasks can be completed quickly and easily, rather than on the tasks that should actually be incentivized.
  • The motivation for collaboration and teamwork may be undermined by the perceived unfairness of the bonus payments.
  • Perceived unfairness can lead to an erosion of trust in management where employees lose the motivation to work hard for their bosses.
  • High performers may become demotivated if other employees receive similar or higher bonuses for less effort.
  • Discretionary bonuses can lead to unhealthy rivalries between colleagues, leading to an overall sense of demotivation throughout the team.

Legal and ethical considerations

Such bonuses can give rise to various legal and ethical considerations around non-discrimination, fairness, and transparency.

To avoid unethical practices and potential legal claims, employers need to establish clear bonus guidelines and carry out their decisions in good faith.

Discrimination must be avoided and the employer needs to provide clear reasoning for why a discretionary bonus has been paid to maintain transparency.

The rules around the discretionary element of these bonuses are laid out in the Fair Labor Standards Act (FLSA). It states that the employer must make decisions around the timing and amount of the payment right before it's made.

Essentially, this means that legally the payment must come as a surprise to the employee and not give the impression that they can expect these payments regularly.

The Employee Bonus Scheme You Should Offer Instead: Profit Sharing

A profit sharing bonus, or plan, involves a company sharing a percentage of the business's profits with its employees.

Unlike discretionary bonuses, the timing and amount are predetermined and are based on quarterly or annual earnings.

As the funds are generated from the company's profits, the employee doesn't pay into a profit sharing plan like they would with a 401(k), for example.

The payments may be distributed as lump-sum bonuses or as part of employees' regular paychecks along with other things like overtime pay.

The eligibility criteria for profit sharing plans vary widely between companies but often include factors such as length of service and exceptional performance.

If you'd like to learn how to calculate profit sharing bonus payments for your employees, then our guide will tell you everything you need to know.

Benefits and effectiveness

A profit sharing plan is one of the best employee incentive ideas for many reasons, including:

  • Long-term focus: Employees have a stake in the long-term success of the company which can lead to increased commitment to the overall performance of the organization.
  • Sense of ownership: By linking their share of profits directly to the performance of the company, employee motivation and productivity can increase. When employees feel a sense of ownership in the company, they become more dedicated to its growth.
  • Flexibility and adaptability: Employers determine the timing and amounts of the payments which means they can be structured to suit the needs of the business. This can help align the company's goals with employee incentives.
  • Retention and engagement: Employees who share in a company's profits tend to be more motivated, engaged, and likely to stay with the organization. They often feel more connected to the business and are easier to retain as they want to share in the business's success.
  • Tax benefits: Depending on how they're structured, these plans can also have certain tax advantages for both employers and employees.

Implementation tips

Here are some tips for implementing a profit sharing plan:

  • Determine the best way to structure the plan for your business. It could be based on annual or quarterly earnings, and it could be a supplemental compensation plan or a retirement plan.
  • Unlike with a discretionary bonus, you need to clearly define the criteria for your employees. This includes when it will be shared and how it will be calculated.
  • Ensure you fully understand the tax implications of implementing your profit sharing plan.
  • Use profit sharing software, like ShareWillow, to create a highly transparent plan.

Other Employee Bonus Options

Some other types of employee bonus options are:

Performance bonuses

A performance bonus is directly tied to an employee's performance. Unlike a discretionary bonus, the employee knows what they need to achieve in order to receive it. However, performance bonuses can create pressure and unhealthy competition among colleagues.

Profit sharing plans are better than both as the payments are linked to the overall success and profitability of the company. The employee knows that if the business prospers, so will they.

Referral bonuses

Such bonuses are paid to employees who refer new hires to the company and are typically awarded after the new employee has been employed for a certain amount of time.

They're good for attracting new team members but have no impact on employee performance or motivation. Their purpose is different to both the discretionary bonus and profit sharing, and they don't have as many positives as either one.

Retention bonuses

A retention bonus is paid to employees who remain with a company for a certain amount of time and can be reasonably effective.

Yet, profit sharing is a much better way of improving retention rates as it encourages employees to remain at a company to share in its profits and overall success.

Offer Your People An Effective Employee Bonus Structure With Our Template

ShareWillow's profit sharing software allows you to design, customize, and manage your plan in one easy place.

It has a user-friendly interface that helps you make your plan as transparent as possible for your employees and features payroll and 401(k) integrations.

If you're ready to start creating your plan today, use our profit sharing plan template which will guide you through the process.

Don't rely on a discretionary bonus to motivate your team. A profit sharing plan has more benefits for your employees and, ultimately, your business.

ABOUT THE AUTHOR

Ryan is the founder of ShareWillow. He's passionate about helping businesses create incentive plans that motivate and reward employees. He previously built and sold PhoneWagon.

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