Rewarding employees is an effective way to boost performance and retain your company’s valuable staff members. More and more employers are turning to incentive-based compensation, such as bonus programs, to motivate their workforce—especially because the economic pinch has made regular pay raises less feasible.

What many employers don’t know, however, is that nondiscretionary bonuses must be computed into nonexempt employee “regular rates” of pay in calculating overtime. A recent California appeals court decision provides some guidance on how bonuses can be calculated into overtime rates.

What Happened

Costco Wholesale Corporation’s bonus program rewarded long-term employees with bonuses if they met certain minimum criteria. Employees with more than 4 years of service received semiannual bonuses if they worked a minimum of 1,000 hours in the 6 months preceding the bonus cutoff date. This bonus is considered “nondiscretionary” because employees who met the minimum service and hour requirements were automatically entitled to the bonus.

California law requires that employers pay daily and weekly overtime to employees, which must be calculated at 1.5 times the employee’s hourly regular pay rate. The regular rate must include all nondiscretionary compensation that the employee receives and is calculated on a weekly basis. Because Costco paid its bonuses on a semiannual (rather than weekly) basis, it had to retroactively calculate the overtime each employee earned on the bonus amounts.

In calculating the overtime owed on bonus amounts paid to its employees, Costco divided the amount of bonus money the employee earned by the minimum number of hours required to be entitled to the bonus (i.e., bonus amount divided by 1,000) to find the hourly bonus rate. This method of calculation yielded the same overtime bonus rate for all employees. Costco then multiplied this overtime bonus rate times the actual number of overtime hours each employee worked, and then multiplied it by .5.

Several Costco employees filed a class action lawsuit, arguing that Costco violated California law because it should have (1) divided the bonus amount earned by the actual number of straight time hours worked (rather than by 1,000) and (2) should have multiplied the overtime hours worked by 1.5 times the hourly bonus rate. The trial court agreed with the employees and awarded the class $5.3 million in back wages, interest, penalties, and attorney’s fees.

What the Court Said

The Court of Appeals reversed the employees’ award, holding that “no California court decision, statute, or regulation governs bonus overtime, the DLSE [Division of Labor Standards Enforcement] Manual sections on the subject do not have the force of law, and the DLSE advice letters on the subject are not on point. Consequently, defendant’s bonus plan cannot be deemed to violate California law.” The court went on to say that Costco’s method for calculating bonus overtime also does not violate federal law because nothing in the federal regulation prohibits Costco’s formula. Marin v. Costco Wholesale Corp., Calif. Court of Appeal (Dist. 1), No. A116847 (2008).

What to Do

Although the court’s decision indicates there’s no clear rule for employers to follow when calculating nondiscretionary bonuses, a few key points are clear. First, it is crystal clear that overtime pay rates must, at some point, include an amount that accounts for nondiscretionary bonuses earned by nonexempt employees. Second, a method for calculating nondiscretionary bonus overtime that at least complies with federal regulations will not run afoul of California law. Beyond those two basic rules, here are some tips that can help you devise a legally sound bonus plan:

1. Make sure you distinguish between nondiscretionary bonuses and commissions. A nondiscretionary bonus is a set amount earned for reaching a particular goal—for example, a percentage of quarterly sales goals met, or a fixed amount earned on an anniversary date or for meeting production goals. Commissions, in contrast, are a percentage amount earned by employees on each sale made.
2. Under the federal bonus overtime formula, an employer can consider bonus amounts to be earned by the employee during both straight time and overtime hours. This means that bonus overtime amounts calculated retroactively can be paid by multiplying the number of overtime hours worked by .5.
3. If you find all of this too confusing or difficult to implement, consider basing your bonuses on merit. Both state and federal law only require that nondiscretionary bonuses be included in overtime calculations. Discretionary bonuses that are not tied to specific sales or production goals, or that are not triggered by some specific event (such as year end or an anniversary date), do not have to be included in overtime calculations.