Employees are a business’s most valuable asset because their skills and abilities help determine the company’s success.

To attract and retain that talent, money talks. But what’s the best way to reward employees for their hard work: a bonus or a pay raise?

Each option has advantages and drawbacks for both the employer and the employee. Let’s break down the key points when choosing between bonus vs raise to help you make an informed decision.

Bonus vs raise

First, let’s clarify some definitions. A bonus is a one-time award for an employee, while a raise is an increase in their salary. Companies usually use bonuses to reward short-term performance, while raises are more of a long-term investment in employees.

That said, there are several different ways to structure bonuses and pay raises.

Defined vs. discretionary bonuses

In most cases, a bonus can be either discretionary or non-discretionary.

• Discretionary bonuses are given at the employer’s discretion, often based on subjective criteria. They’re not outlined in the employee’s contract, so they’re not guaranteed. Examples of discretionary bonuses include annual bonuses when the company has a successful year or holiday bonuses that aren’t tied to business profits or work performance but are a gesture of gratitude. These bonuses provide flexibility for the employer but can lead to uncertainty and dissatisfaction among employees if the business doesn’t properly manage expectations.
• Non-discretionary bonuses (also known as defined bonuses) are pre-determined and often tied to specific performance metrics or company profits. They’re a part of the employee’s contract. As long as the employee (or the company) meets the requirements outlined in their contract, the business owner must pay the bonus as part of the employee’s compensation package. An example of a non-discretionary bonus is a profit-sharing plan where the company distributes a certain percentage of the company’s quarterly or annual profits to employees, usually based on each employee’s yearly salary. Employees know what to expect, which can drive performance and loyalty.

Other types of bonuses companies might give include:

• Spot bonuses. These are usually relatively small bonuses — $50 to $100 — for employees who go above and beyond.
• Sign-on bonuses. Companies might offer sign-on bonuses when trying to recruit high performers.
• Retention bonuses. Employers give these to current employees to entice them to stay with the organization.
• Referral bonuses. This payment is given to employees who recruit talent to join the company.

Benefits and downsides of bonus pay

For employers, the flexibility of bonuses can be appealing. Bonuses are not a recurring expense, making them more financially feasible, especially in uncertain economic times. Companies can adjust or even eliminate bonuses in lean years, which is much easier than reducing employees’ base salaries.

However, this flexibility comes at a cost. It might be challenging to attract top talent if compensation isn’t pegged to the market rate for their work.

Let’s consider an example. Say you hire an office manager and pay them a base salary of $85,000, which is about the average for an office manager in the United States the year you hire them.

You also have a profit-sharing plan that gives employees an annual bonus of 3% of their salary. In the first year or two of this arrangement, the employee is happy with their base pay and delighted by receiving a lump sum bonus of $2,550 (3% of $85,000) at the end of the year.

However, five years go by, and the picture isn’t so rosy for the employee. Average salaries for office managers have increased along with inflation, but their salary has remained the same. Their bonus doesn’t change because it’s a percentage of their salary.

Let’s say instead of a bonus, you gave that employee a 3% raise each year. The table below shows the total compensation over a five-year period.

Year	Bonuses (3% of salary per year)			Raises (3% per year)
	Salary	Bonus	Total Compensation	Salary	Bonus	Total Compensation
1	$85,000	$2,550	$87,550	$85,000	$0	$85,000
2	$85,000	$2,550	$87,550	$87,550	$0	$87,550
3	$85,000	$2,550	$87,550	$90,177	$0	$90,177
4	$85,000	$2,550	$87,550	$92,882	$0	$92,882
5	$85,000	$2,550	$87,550	$95,668	$0	$95,668

As you can see from the table, by Year 5, the employee is earning over $8,000 more than they would have if they’d received only bonuses instead of raises.

Over time, your office manager finds that relying solely on bonuses means they’re missing out on the exponential growth that comes with salary raises calculated as a percentage of their base pay, and they start looking for another job.

Pros and cons of a permanent raise

Pay raises are usually more attractive than a bonus for employees because they offer more stability and security. However, a pay increase also provides advantages for employers.

Pay increases motivate staff members to stay with your company longer because they feel appreciated for their hard work and motivated to continue growing their careers.

On the other hand, a salary increase can be expensive for a business, and they’re something small businesses have to budget for every year.

Pay raise vs bonus: Finding the right balance

When deciding whether to offer bonuses or raises, consider the following:

• Employee morale and retention. Regular raises can improve staff morale and retention by providing financial stability and acknowledging long-term value.
• Financial flexibility. Bonuses offer financial flexibility, allowing companies to reward employees without committing to permanent salary increases.
• Market competitiveness. To attract and retain top talent, make sure your base salaries are competitive with market rates. Then, you can complement base pay with performance-based bonuses where appropriate.
• Cost of living adjustments. Even if you lean toward bonuses, periodically increase salaries to help employees keep pace with inflation and rising living costs.

While bonuses can be an attractive addition to an employee’s compensation package, they shouldn’t replace the foundation of regular salary increases. A balanced approach that offers competitive salaries and performance-based bonuses can help you attract and retain top-tier talent while maintaining financial flexibility. After all, happy and financially secure company employees are likely to be more productive and loyal team members.

If you need help finding that balance, please reach out. We can help you run the numbers and create a total compensation package that rewards individual performance and helps you attract workers who contribute to your company’s revenue and bottom line.