One of the core functions of human resource management is the development of a compensation system. In this lesson, you’ll learn about the different methods organizations use to compensate their employees. A short quiz follows.

Compensation System Defined

Brittany works as an HR specialist for a large corporation that manufactures microchips. She specializes in compensation and benefit administration. Part of her job is to periodically review and recommend advisable changes to the company’s compensation system.

A compensation system is the sum total of all monetary and non-monetary benefits provided to employees in exchange for their willingness to work. Compensation can be broken down into three general categories:

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  • Direct financial compensation is monetary compensation, such as wages, salaries, commission and performance payments. This is the type of compensation that we’ll be focusing on in this lesson.
  • Indirect financial compensation includes compensation that has financial value but does not consist of a direct monetary payment to an employee. You can think of it as a non-cash benefit. Examples include paid time off, health insurance, life insurance, disability insurance, stock options plans and services provided to employees, such as financial counseling.
  • Non-financial compensation doesn’t have any monetary or economic value per se, but it involves the satisfaction an employee receives from the work environment.

Salary and Wages

William is like the vast majority of workers and is paid an hourly wage by the company. A wage is simply a specific sum of money paid for each hour worked. Of course, employees are paid for partial hours worked as well.

The Fair Labor Standard Act (FLSA) requires wage employees to be paid an overtime rate of pay at least one-and-a-half times their regular wage for any time worked over 40 hours during a weekly pay period. For example, William makes $15 per hour and is paid $22.50 per hour if he works overtime. Samantha is an executive who works in marketing. She’s not paid a wage. Instead, she’s paid a salary.

A salary is a set amount of compensation paid, regardless of the amount of work performed. It is often calculated on an annual basis and paid out on a monthly basis. For example, Samantha’s current salary is $60,000 per year and is paid in 12 monthly installments of $5,000.

Samantha’s job qualifies her as an exempt employee, which means she is not covered by the overtime provisions of the FLSA. Some of the most important exemptions to overtime pay include executive, administrative, professional, outside sales and other highly compensated employees. Each exemption requires certain criteria to be met, including a minimum level of pay.


Carl works in sales. He’s paid a salary and is also entitled to earn commission. A commission is a payment a salesperson receives for selling a product or service and is usually based upon a percentage of the revenue the salesperson brings into the company from sales. Carl gets two percent of each dollar of revenue he generates in sales. So, if he brings in $2,000,000 in sales during the year, he earns $40,000 in commission. This is in addition to his regular salary.

Some salespeople work on straight commission, which means they are only paid commissions. The commission rates are usually significantly higher than if a salary or wage is also paid. Of course, if no sales are made, no pay is given regardless of the amount of work put in. However, straight commission arrangements can be highly lucrative to successful salespeople in the correct sales environment. A six or seven figure income is possible.


Patrick is an associate at a law firm that has adopted a pay-for-performance system. Like commission, it’s a variable-based pay plan, which means there is some variability in the amount of compensation that an employee will receive. Patrick receives a base salary and may qualify for additional pay throughout the year based upon his performance. For example, he may be required to bill 2,000 hours per year, which is 500 hours per quarter. At the end of each quarter, he may receive a performance bonus if his billable hours exceeded 500.

Contractors and Compensation

Irene is an independent contractor. She works for different companies as a consultant on a case-by-case basis. She is not an employee of any of the companies, and they do not withhold payroll taxes. Instead, Irene is paid according to the terms of her contract, and she is responsible for paying not only income but self-employment taxes.

Lesson Summary

Let’s review what we’ve learned. A compensation system is all the financial and non-financial value workers receive from an organization in exchange for their labor. You can divide compensation into three separate categories: direct financial compensation, indirect financial compensation and non-financial compensation. Typical forms of direct financial compensation include wages, salaries, commissions and pay-for-performance pay. Independent contractors are paid pursuant to the terms of their contract with the company.

Learning Outcomes

Once you have reviewed this lesson you should be able to:

  • State three common types of compensation
  • Discuss examples of each type of compensation