As an employer, you need a structure and method for paying your employees. Enter: an equitable, comprehensive compensation model. In this article, we’re sharing everything you need to know about compensation models, including what they are, why they’re valuable, and how to build one that works for your business. 

What is a compensation model?

Also called a compensation plan, a compensation model is the structure for how and why you compensate employees for their work. Along with a detailed breakdown of employee wages and benefits, the compensation model should also include your business’s compensation philosophy, process for determining pay, and information on employment laws that pertain to your business. 

Why is a compensation model important for your business? 

Compensation models aren’t just nice to have—they’re necessary for effective business operations and employment practices. Here are five key areas where compensation models make a difference: 

1. Strategy: A compensation model describes how your pay philosophies support your business model and growth strategy. 
2. Equity: Creating a compensation plan helps ensure you’re providing reasonable and equitable compensation for the jobs you hire for. 
3. Compliance: A compensation plan keeps you compliant with local, state, federal, and industry regulations and laws. 
4. Recruiting and hiring: Not only does a compensation plan provide a structure for recruiting and hiring within your business, it can also help you improve your pay practices and stay competitive within your industry.  
5. Employee satisfaction: Sharing your compensation model with your employees can help them better understand their total compensation package—and figure out which steps to take to earn a raise or bonus. 

3 different types of compensation to include in your compensation model

A compensation model includes all the different types of compensation you offer employees, including direct compensation, indirect compensation, and non-financial compensation. Let’s explore each one below. 

Direct compensation is what employees get for the jobs they perform. This includes base pay—the amount of pay employees receive at minimum—and variable pay, which is extra on top of the base. Base pay includes salaries and hourly wages, while variable pay includes commissions, bonuses, and tips.

Indirect compensation refers to the monetary benefits employees receive as part of their job. These can include: 

• Health insurance
• Retirement benefits
• Paid time off
• Stipends for commuting, learning materials, personal development, wellness, etc.
• Stock options
• Tuition assistance
• Incentives 

Non-financial compensation refers to the non-monetary benefits employees receive as part of their job or as performance incentives. These can include:  

• Company equipment and tools
• Flexible work hours/schedule
• Remote work options
• Training programs
• Free meals or snacks 
• Childcare assistance

You may not be able to afford or offer every type of compensation listed above, but it’s smart to strive for a balance. A healthy compensation package usually includes a mix of all three types of compensation. 

Want to learn more about compensation? Check out Gusto’s helpful guides on everything from pay stub specifics to paying yourself as a business owner. 

How to create a compensation plan in 6 steps

A great compensation plan is transparent, thorough, and consistent. Whether you need to create a compensation plan for the first time or update the one you have in place, here are the steps to take:

1. Clarify your compensation philosophy

Your business’s compensation philosophy is the foundation of your entire compensation model. Your goals and values around pay inform how you structure your total compensation package—and which factors you rely on to determine each person’s pay. 

Taking the time to write down your compensation philosophy can help stay on track with your larger business goals. Plus, sharing your compensation philosophy with your business’s leadership and management teams gets on the same page regarding recruitment, hiring, and promotion processes. 

Aim to use simple, clear language so everyone in your business can understand. Here’s what you should include: 

• The why behind your philosophy: Think about your business’s mission, values, long-term vision, and employee care practices, then explain how your compensation philosophy aligns with and reflects those factors.  
• What’s included in your compensation: List out and give examples of the different types of compensation your business offers—including employee benefits—and why. 
• The factors that determine your compensation design: Make sure you list out and explain which specific factors you account for when determining the different pay applications for the roles you hire for (more on this later).

If you need more information before you complete your compensation philosophy, no problem—just follow the rest of the steps below, then come back and fill in any gaps in this section afterward. 

2. Do a job analysis for roles in your business 

Analyzing the various roles within your operation can give you a clearer idea of the appropriate compensation for each role. Gather the following information for each role:

• Job title
• High-level job description
• Job classification (eg. entry level, senior, etc.)
• Which tasks and responsibilities the job requires at minimum
• Which additional tasks and responsibilities the job might include 
• Which specific skills and abilities the job requires 
• Job difficulty level
• Impact of the job on your business
• The milestones or performance indicators an employee needs to demonstrate to earn a raise in the role
• The milestones or performance indicators an employee needs to demonstrate to earn a promotion in the role
• Amount of compensation you’ve offered for the role in the past
• Average industry pay for the role 
• Average market pay for the role
• Cost of living in the location where the role takes place

3. Do market research

To get an accurate idea of what other businesses of your industry, size, and location pay workers, you need to conduct market research. The data you collect can serve as the starting point for refining your compensation structure. 

Plus, market research shows you where your business falls in terms of compensation—whether you’re matching the market (doing what your competitors are doing), leading the market (raising the standard for your competitors), or lagging behind it (offering less compared to your competitors). 

As you research, aim to gather the following data: 

• Nationwide average market pay for the roles you hire for
• Average employee pay for businesses that bring in the same revenue as your business
• Average employee pay for businesses with the same number of employees you have
• Average employee pay for businesses in your same location 

In addition to scouring job search sites for information, you can search for specific compensation reports and surveys in your industry, state, and region. It’s also helpful to reach out to other business owners in your community or look to your professional networks and groups for intel or advice. 

4. Develop a compensation budget

Before you define your compensation package, it’s a good idea to develop a compensation budget. Start by reviewing your business’s finances, including your current labor costs, annual income statements, balance sheets, and cash flow forecasts. 

Taking into account your updated compensation philosophy and the data you gathered in your market research, work with your CFO or business accountant to create a realistic budget for your total compensation offerings. 

Your budget should include:

• Wages and salaries
• Commissions and bonuses
• Payroll taxes
• Health insurance costs
• Employer contributions to retirement accounts  
• Employee benefits  

5. Note the employment laws you need to abide by

The employment laws in your particular region, state, and industry can affect your compensation structure, so it’s crucial to take note of the laws that apply to your business. A good place to start is your state’s labor office. Pay special attention to:

• Minimum wage requirements
• Pay transparency and reporting requirements
• Employee classification requirements 
• Workers compensation insurance 
• Overtime pay requirements 
• Pay equity laws

6. Define your compensation structure

The final step in creating a compensation model is to define your compensation structure. You’ll need to list out the various types of direct, indirect, and non-financial compensation your business offers. 

From there, list and explain the specific factors that affect your compensation ranges. Most businesses rely on a mix of factors, including: 

• Company details: Your industry, business’s financial position, business size, location, business growth objectives
• External conditions: Market rate for different positions, cost of living in business’s location, and economic conditions like inflation 
• Job characteristics: Job level/classification, level of difficulty/skill required, impact on business 
• Employee characteristics: Education level, work experience, skillset, unique attributes, job performance 

This is also the place to explain your business’s process for determining goals and benchmarks for each role, conducting performance evaluations, accounting for pay equity, and evaluating raise and promotion opportunities. 

Review your compensation model regularly 

Compensation models aren’t set in stone. They should evolve with your business’s growth and account for changes in the market. Strive to evaluate your compensation plan at least once a year, and potentially biannually if you’re growing quickly.