Retroactive pay: What is it, how to issue, and retroactive payment examples

One of an employer’s primary responsibilities is to ensure that their team has been compensated accurately and on time at the end of each pay period. But as a human, you know that mistakes can happen. Retroactive pay is how employers can rectify payroll errors, righting wrongs with their team and their financial records.

In this post, we’re taking a closer look at retroactive pay, how it works, its legal considerations, and more. Read on for an extensive overview of retroactive pay, or click on a link below to navigate to the subtopic that best answers your query.

• What is retroactive pay?
• Calculating retroactive pay
• Retroactive pay taxes
• Legal considerations
• Ways to issue retro pay
• Final thoughts

Retroactive pay is when a business issues its employee(s) money to correct underpayment during a given pay period. The need for retroactive pay doesn’t usually come up very often. It can happen when raises are issued in the middle of a pay cycle, a contract is being negotiated, or an accounting mistake is made. Retroactive payment can also be court-ordered—we’ll discuss that in more detail a little later on in this post.

Bottom line: Retroactive pay is used to pay employees back when they’re not initially compensated for the amount agreed upon.

• A pay increase was authorized but was not reflected on the employee’s paycheck.
• A payroll or accounting error occurred when processing payroll.
• An employee worked overtime hours but overtime pay wasn’t calculated accurately.
• A bonus, commission, or another special type of pay wasn’t accounted for or was underpaid.

Retroactive pay and back pay are oftentimes used interchangeably. While both are payments issued after the original pay period, they have some key differences for employers to be aware of. Let’s take a look.

• Retroactive pay: The remaining balance an employer owes to a worker, compared to what was originally issued during the pay period.

• Back pay:  Payment to catch up on compensation that was never issued for work that was carried out. Usually, back pay is brought on by a lawsuit in which an employer failed to pay salaries due. The judge generally issues particular orders on back pay, fines, and restitution.

Put simply, retroactive pay occurs when your employee is paid less than they should’ve been paid, whereas back pay is used when a worker isn’t paid at all.

If you discover a payroll error or are alerted to one by an employee, you’ll want to resolve it ASAP. How you calculate retro pay depends on how you classify the employee affected—retro pay is computed differently for salaried employees and hourly employees.

Calculating retroactive pay for hourly employees involves a few simple steps:

Step 1: Determine the correct hourly rate: This rate is established through a variety of factors, such as a raise, a promotion, a contract renegotiation, or the correction of an error in their previous pay. Be sure to have clear documentation to support the new rate.

Step 2: Calculate the difference in hourly rates: Subtract the old or incorrect hourly rate from the new or correct rate to determine the amount the employee was underpaid per hour. This difference is the basis for calculating the retroactive pay adjustment.

Step 3: Identify the number of hours worked at the old rate: Determine the number of hours the employee worked at the old or incorrect rate during the specific time period for which retro pay is being calculated. This could be a week, a month, or even several months, depending on the situation.

Step 4: Calculate total retroactive pay: Multiply the difference in hourly rates (Step 2) by the number of hours worked at the old rate (Step 3). This will give you the total amount of retro pay owed to the employee, representing the difference between what they were paid and what they should have been paid.

Example:

An employee was paid $15 per hour but should have been paid $16 per hour. They worked 40 hours during the affected pay period.

Step 1: The correct hourly rate is $16.

Step 2: The difference in hourly rates is $16 - $15 = $1.

Step 3: The employee worked 40 hours at the old rate.

Step 4: The total retro pay owed is $1 x 40 hours = $40.

Therefore, the employee is owed $40 in retroactive pay.

Typically, retroactive payments are added onto the employee’s next paycheck. So don’t forget to add the amount owed in retro pay to the number of hours worked during the current pay period. We’ll discuss other ways of issuing retro pay a little later on in this post.

Calculating retroactive pay for a salaried employee with a raise involves several steps: 

Step 1: Determine new pay per paycheck: Divide the employee's new annual salary by the number of pay periods in a year (e.g., 26 for bi-weekly, 12 for monthly).

Step 2: Calculate old pay per paycheck: Divide the employee's old annual salary by the number of pay periods in a year.

Step 3: Find the difference: Subtract the old pay per paycheck (Step 2) from the new pay per paycheck (Step 1). This is the increase per paycheck.

Step 4: Issue retroactive pay: Multiply the difference in pay per paycheck (Step 3) by the number of paychecks the employee received at the old rate since the raise took effect.

Example:

An employee's salary increased from $60,000 to $65,000 annually, and they are paid bi-weekly.

• Step 1: New pay per paycheck: $65,000 / 26 = $2,500
• Step 2: Old pay per paycheck: $60,000 / 26 = $2,307.69
• Step 3: Difference in pay: $2,500 - $2,307.69 = $192.31
• Step 4: If one paycheck was issued at the old rate, the retroactive pay would be $192.31.

Remember: The effective date of the raise is crucial for determining how many paychecks were issued at the old rate. Ensure you have the correct information to calculate accurate retro pay.

Just like regular pay, retroactive pay is subject to taxes, including:

• Federal income tax
• State income tax
• Local income tax
• Social Security
• Medicare

When you make retroactive payments to employees, you’ll still need to withhold the appropriate amount based on the sum of the retro pay.

In addition to the examples of retroactive pay discussed above, there are certain cases where retro pay may be court ordered. Here are some circumstances when a judge may order retro pay by law:

If a judge determines an employer issued pay increases to a segmented group based on characteristics like race or gender, they may award retro pay to affected employees. In 2023, the U.S. Equal Employment Opportunity Commission secured more than $665 million for victims of discrimination.

A judge may order retro pay if a business withholds pay or pay increases because it’s retaliating against an employee for whistleblowing. An estimated 43% of workers who report wage theft also experience some form of retaliation that may also constitute retroactive payment.

When an organization knowingly violates an employment contract and pays less than the agreed-upon rate, retroactive payments may be demanded by a court of law.

Retro pay may be ordered if an employer fails to compensate employees appropriately according to their overtime rate. (Overtime is time and a half, according to Fair Labor Standards Act [FLSA] standards). According to the Department of Labor, back wages for overtime violations in 2023 amounted to $130,686,461.

If an employer is caught paying employees under the table for less than minimum wage, a judge may require the employer to issue retro pay.

If an employer pays workers less than the FLSA minimum wage, they may be subject to retro pay. Per the Economic Policy Institute, roughly 2.4 million workers covered by state or federal minimum wage laws were paid less than their state’s minimum wage each year.

Now that you’re familiar with how retro pay works and when it might be necessary, let’s discuss your options for issuing retro pay.

1. Issue a lump sum payment on a separate check
2. Include retro pay in the employee’s next paycheck and label the amount as “RETRO”
3. Add retro pay to their regular pay on their next paycheck—no need to label

Mistakes happen—from missing the memo on a salary increase to omitting overtime, payroll errors shouldn’t be something to panic about. With QuickBooks, you can streamline your payroll system and accounting to avoid errors from the start and, if needed, resolve them with ease.

Whether you’re managing payroll in-house or choose to outsource your payroll, QuickBooks can help you stay organized and ensure accuracy. Plus, access features like free cash flow reporting to set the stage for financial growth, and enjoy a user-friendly experience that saves on accounting time.