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

Paying employees on time is a must, but some companies struggle with this from time to time. According to a QuickBooks study on the State of Small Business Cash Flow, 61% of small businesses worldwide struggle with cash flow, and nearly a third (32%) either pay vendors and lenders late or can't pay themselves or their employees due to cash flow issues.

If you fall into that bucket, your staff or vendors may be entitled to retroactive pay. Making retroactive payments can help you avoid penalties for not paying employees and earn back employee trust by ensuring timely payment. 

This guide will explain retroactive pay, when it is needed, and how to pay back when required.

What is retroactive pay?

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. 

Bottom line: Retroactive pay is what businesses use to pay employees back when they’re not initially compensated for their work.

Examples of retroactive pay:

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

Retroactive pay vs. back pay

Retroactive pay and back pay are often used interchangeably. While both are payments issued after the original pay period, there are some key differences for employers to be aware of. So what's retroactive pay versus back pay? 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 the employee's work. Usually, it's brought on by a lawsuit in which an employer failed to pay salaries due. The judge generally issues orders on back pay, fines, and restitution.

Put simply, retroactive pay occurs when an employee receives less than they should’ve received, whereas back pay is used when a worker isn’t paid.

You can issue retroactive pay in one of three ways:

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.

How to calculate retroactive pay for hourly employees

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. 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.

How to calculate retro pay for salaried employees

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 of calculating retroactive pay when you paid the wrong amount

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 to the employee’s next paycheck. So, remember 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 in this post.

Example of calculating retroactive pay after a salary increase

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.

Understanding retroactive pay taxes

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

Legal considerations

The legal system aims to ensure that employees are compensated fairly and in accordance with the law for all hours worked. Here are some circumstances when a judge may order retro pay by law:

Discrimination

If a judge determines that an employer issued pay increases to a segmented group based on characteristics like race or gender, they may award retro pay to affected employees. Discrimination is on the rise. 

According to the US Equal Employment Opportunity Commission (EEOC), there was a 9% increase in discrimination charges filed from October 1, 2023, to September 30, 2024.

Retaliation

A judge may order retro pay if a business withholds pay or pay increases because it’s retaliating against an employee for whistleblowing. The Department of Labor (DOL) makes it clear that retaliation is unlawful. 

Breach of contract

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.

Overtime violations

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.

Under-the-table pay

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 because of payroll fraud.

Less than minimum wage

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.

How to reduce payroll errors in your business

Preventing retroactive pay begins with a smart approach towards payroll. You can significantly reduce the risk of payroll discrepancies that lead to retroactive pay by: 

1. Establishing a payroll review and payroll reconciliation process. Develop a system that includes regular checks for payroll accuracy before each pay cycle. This helps you catch mistakes before paychecks are issued.
2. Requiring multiple people to review and sign off on payroll. Having multiple eyes on things reduces the chance of potential mistakes that necessitate back pay later.
3. Look for data entry errors. Before payroll is processed, do an audit to identify and correct mistakes in employee data, such as hours worked, overtime, or deductions.
4. Reconcile timekeeping records with payroll entries regularly. Compare time tracking data with payroll records to ensure all hours your employees worked are accurately recorded and paid for. 
5. Communicate pay changes early and effectively. Establish a clear line of communication between HR, management, and payroll teams to ensure that updates to employee pay, such as added income from a raise, are shared with everyone who needs the details.
6. Document all compensation changes. This means writing down when someone's compensation changes. Always include the effective date when recording pay changes to ensure employees are compensated correctly from the right date.
7. Communicate pay changes to employees. To reduce conflict or confusion, keep employees informed about any changes to pay scales or bonus structures. 
8. Take advantage of payroll technology. Payroll software can automate complex calculations and processes, reducing human error and simplifying compliance.
9. Use integrated time tracking and payroll systems.  By using an app that syncs payroll and time keeping, employers can eliminate manual entry errors and ensure accurate pay based on actual hours worked.

By taking these proactive measures, employers can build a more accurate and transparent payroll process and reduce the likelihood of retroactive pay corrections.

Best practices for managing retroactive payments efficiently

Once your company is in a situation where retroactive pay is needed, you'll need a process for issuing retroactive pay while maintaining full compliance with the law. Here are some steps to take:

1. Calculate the owed amount

Before making any payment, the first and most critical step is to calculate the total amount of retro pay owed accurately. This includes thoroughly reviewing the period, accounting for missed hours, overtime, bonuses, or pay rate changes. 

Use payroll software or a dedicated calculator to ensure accuracy, which helps prevent further errors and ensures the calculation is correct from the start.

2. Distribute the payment efficiently

Once the amount is verified, process the payment as soon as possible. Whenever possible, include the retro pay in the employee's next regular paycheck. If there's a significant delay, you can make an off-cycle payment to get the money to the employee faster. 

In the pay stub, clearly label the retro portion of the payment, detailing the pay period it covers, the original error, and the corrected amount. This transparency helps the employee understand the payment breakdown and avoids confusion.

3. Apply correct tax withholdings and reporting

Retroactive pay is subject to the same federal, state, and local taxes as regular wages. It's crucial to apply the correct withholdings for income, Social Security, and Medicare taxes based on the date the payment is issued. This payment date is what determines the tax year for reporting purposes. 

Ensure that the retro pay is properly reflected on the employee's W-2 and in your company's quarterly payroll filings to maintain compliance with all tax regulations.

4. Maintain thorough documentation

Keep detailed records of the error, the calculation used to correct it, who approved the payment, and the date it was processed. This creates a clear audit trail that is essential for future reference, especially in an audit or an employee dispute. 

Additionally, notify the employee promptly once the payment is processed, providing them with details on the amount, what it covers, and who to contact with any questions.

Next steps for streamlining your payroll process 

Managing retroactive pay can be time-consuming, and there's a risk of mistakes without the right tools in place. The best way to reduce the headaches associated with retroactive pay is to streamline your payroll process from the start. 

With solutions like payroll software, you can minimize errors, automate your calculations, ensure timely payments, and avoid having to figure out how to calculate retroactive pay. 

If you're ready to take control of retroactive cash flow, try QuickBooks Payroll today.