What are Discretionary Bonuses? (And How To Use Them)

Discretionary bonuses can be a great strategy to boost employee morale — as long as you use them properly. Remaining compliant with federal laws will save you and your employees a lot of stress.

But what makes a bonus discretionary?

A discretionary bonus is at the employer's discretion. However, before you start handing out bonuses “at your discretion,” there are a few key issues to keep in mind to use them properly. Not every bonus that appears discretionary is considered so under the law. If you provide any bonus under the wrong circumstances, you may end up with serious legal or tax headaches.

Let’s look closer at discretionary bonuses, how they are defined, and best practices for implementing them the right way.

What Is a Discretionary Bonus?

A discretionary bonus is a bonus given at the employer's express discretion. By definition, it is unplanned and given outside of the normal compensation plan or performance-based incentive plans. Some examples include Christmas-time bonuses that aren’t dependent on an employee’s performance, or random gifts to your team members to show appreciation. These bonuses are meant to boost morale and recognize extra effort.

Discretionary vs. Non-Discretionary Bonuses

In contrast, non-discretionary bonuses follow standardized criteria that are well known across an organization. Employees understand exactly which actions trigger a specific reward as part of formalized incentive plans. As a result, nondiscretionary bonuses are included in the Department of Labor (DOL)’s definition of the regular rate of pay.

Companies often add bonuses to normal employee wages to incentivize performance or reward safety guideline adherence. These are often considered non-discretionary bonuses.

A bonus is considered non-discretionary if it falls into the following types of payouts:

• Performance bonuses: Awards tied to achievement of predefined targets for metrics like sales, customer satisfaction, quality levels, or budget goals over specific measurement periods.
• Referral bonuses: Fixed rewards for bringing in new hires who successfully complete their probationary period.
• Attendance bonuses: Regular small bonuses are given for maintaining perfect daily attendance over set timeframes.
• Commission payments: Sales teams receive these payouts (calculated as fixed percentages per sale or deal) to fuel greater revenue production. These can make overtime exemptions a bit complicated.

Why Does This Matter?

According to the DOL, the primary reason for distinguishing between discretionary and non-discretionary bonuses is their impact on overtime pay calculations under the Fair Labor Standards Act (FLSA).

Specifically, non-discretionary bonuses must be included when determining a non-exempt employee's regular rate of pay (used to calculate overtime pay). Including these bonuses ensures employees are fairly compensated. In contrast, certain gifts like discretionary bonuses may be excluded from this calculation.

Risk of Misclassification

You may be tempted to save money simply by labeling non-discretionary payments as discretionary. However, doing so carries significant legal and financial risks including:

• FLSA violations if inappropriately excluded from overtime rates
• Employee backlash from perceived unfairness
• Tax/insurance noncompliance for misreported wages

Don’t take these risks lightly.Properly handling bonuses is a crucial responsibility, and it affects more than just your accounting team. Knowing how a certain type of bonus program will be classified determines how your HR team will deploy it for the best effect.

Legal Requirements of Discretionary Bonuses

To be considered a discretionary bonus, the payout needs to meet the following criteria:

1. Given at discretion of employer: The employer solely decides whether to award a bonus, and determines its amount. There are no contractual obligations or implied expectations from employees to receive the bonus.
2. Variable timing: Discretionary bonuses are given with no advanced notice or regularly scheduled review. They aren’t tied to factors like annual performance, either.
3. No expectation of recurrence: Each bonus of its kind stands independently. Employees can’t depend on continuing to receive discretionary rewards. Otherwise, the rewards would be considered wages.

Understanding these requirements brings clarity to your leadership and HR teams so you can prevent compliance missteps.

Other Legal Requirements to Consider

In addition to the criteria for discretionary bonuses, companies should be aware of legal compliance standards. These include:

• Employer-driven decisions: Bonuses should purely reflect internal leadership decisions rather than external pressures from staff. There cannot be explicit or implicit expectations set with employees.
• No previous mentions: Carefully avoid any references to potential bonus payments in contracts, employee handbooks, or verbal discussions, as these could be construed as guaranteed future payments that invalidate discretionary status.
• Fair Labor Standards ACT (FLSA) adherence: Confirm discretionary bonus classifications align with FLSA guidance around appropriate inclusion in regular compensation rate calculations for overtime and other pay entitlements. Misclassification can yield penalties.
• IRS/taxation rules: While discretionary bonus payments aren’t considered “wages” in the same way non-discretionary payments are, these amounts still get reported as taxable income. Employers must properly handle withholding at the applicable supplemental rate and submit associated reporting to avoid IRS penalties.

How to Use Discretionary Bonuses

To implement discretionary bonuses in your rewards and recognition program, first establish clear guidelines that define the purpose, criteria, and timing of the rewards. By ensuring these bonuses are truly discretionary (not expected) and not tied to any specific performance metrics, you can effectively use them to motivate and appreciate your employees. Here are a few ideas and best practices for deploying discretionary payments.

Determine Your Available Budget

To use discretionary bonuses effectively, start by establishing a proper budget. The money for any incentive program must be accounted for, and kept separate from funds allocated for wages. Discretionary compensation planning helps establish affordable budgets for surprise expenditures apart from standard wages and incentive plans.

Implement a System That Can Easily Handle Discretionary Bonuses

There’s nothing worse than having an incentive program in place, but trying to manage it with systems that can’t keep up. Ensure that your Payroll or Human Capital Management (HCM) system incorporates these approaches. Otherwise, you’re dealing with a lot of manual entry and potentially incorrect pay/taxes and other challenges.

Consider Company Performance

While discretionary awards are not directly tied to specific performance metrics, overall company performance should still play a role in deciding how much to allocate for these bonuses.

For example, a strong financial year might justify more generous bonus payouts, while a learner period might demand more conservative spending the next year. Overall, analyzing broader performance can provide context for responsible and reasonable spending levels.

Establish Clear Award Levels

It’s also a good idea to define tiered bonus levels based on various factors, such as employee seniority, specific contributions to the company, special achievements, and more. Make sure to set upper limits on surprise reward amounts.

Here’s an example of how you might specify tiers for certain awards:

• Spot Awards ($100 to $500)
• Quarterly Culture Bonuses ($250 to $1000)
• Special Project Bonuses ($500 to $2000)
• Annual Seasonal Bonuses ($1000 to $4000)

Examples of Discretionary Bonuses

Now that you understand the foundation of discretionary bonuses, here’s what these payments could look like practically:

• Spot bonuses: These can be given to individual employees for high-impact performance, noteworthy achievements, and to encourage excellence.
• Random gestures: Gifts like extra paid time off or gift cards can be given to select employees at the leadership team’s discretion.
• Holiday or year-end bonuses: Cash gifts around the holidays boost morale during a busy and often stressful time of year without creating undue expectations.
• Personal milestone awards: Gifts or cash bonuses in honor of an employee’s major life event like a wedding or the birth of a child can be considered discretionary bonuses. These can help cultivate cultural engagement outside of formal programs.

NOTE: While some of these examples could potentially conflict with the DOL's guidelines on discretionary bonuses, the key is to implement them carefully. When in doubt, consult a lawyer experienced in employment law.

To help tailor your bonuses and keep them discretionary, avoid regularity, communicate discretion, and document your bonuses thoroughly. For instance, leadership may give bonuses at unpredictable times when management recognizes exceptional contributions to the company (without creating an expectation of receiving them). When these bonuses are administered, HR should clearly communicate to employees that such bonuses are not guaranteed — they are awarded at the discretion of management based on subjective assessment.

Likewise, any policy or announcement regarding these bonuses should emphasize their discretionary nature and clarify that the company reserves the right to modify, suspend, or discontinue the bonuses at any time.

Common  Bonus Scenarios: Is It Discretionary?

1. Holiday Cash Awards

Scenario: You surprise your employees with a $500 bonus in December.

Is it discretionary? Yes. The payment timing and amount is at the employer’s full discretion and not contractually obligated.

2. Attendance Lottery

Scenario: Employees with perfect attendance for the month are entered into a random raffle for $100 cash prizes. Program details are promoted openly.

Is it discretionary? No. The reward relates directly to meeting an attendance goal, which is an expected reward in exchange for a certain outcome.

3. Safety Excellence Recognition

Scenario: An employee significantly improved warehouse safety processes and was awarded a $5,000 spot bonus at a town hall.

Is it discretionary? Yes. The unscheduled, performance-based award reflects employer discretion.

Final Thoughts

Discretionary bonuses are an excellent way to affordably provide extra compensation at times that are convenient for the company. As long as the payout isn’t planned or outlined, it remains discretionary, thereby allowing employers to freely reward employees without fumbling around with complex overtime calculations.

Because it can be easy to misclassify bonuses and impact overtime pay or workers’ compensation premiums — getting it right is a must.

Criterion HCM alleviates typical headaches for organizations managing discretionary bonuses by automating complex calculations. Our platform incorporates details like pay rates, tax rates, and more into the payroll process — with the flexibility to track bonuses in the same interface. We also help your organization remain compliant with FLSA requirements, IRS reporting, tax withholdings, and more.

Discover an HCM that’s completely configurable to meet your unique payroll and talent engagement needs. Book a demo to learn how Criterion can handle your toughest HR challenges.