Should You Pay Employees an Hourly Wage or a Salary?

This story appears in the July 2014 issue of Entrepreneur. Subscribe »

This subject is covered by the Fair Labor Standards Act of 1938 (FLSA) and its accompanying regulations. The law spells out, among other things, minimum wages, rules about determining hours worked and the definitions and treatment of nonexempt and exempt employees for overtime pay.

Overtime, in fact, is one of the critical considerations in determining how to pay your staff. Nonexempt employees--typically those who get an hourly wage--must be paid overtime when they work more than 40 hours per week. Exempt employees do not receive overtime. (We commonly call these salaried employees, but the kicker is that even some salaried employees may actually be considered nonexempt and subject to overtime pay.) To make matters even more confusing, each state has its own "wages and hours" laws, and they're usually more stringent than the FLSA's requirements.

Almost every company for which I've worked or consulted--including those that were making an honest effort to do right by their employees--has encountered issues related to the FLSA. In short, you need help from the experts: employment-law attorneys, some CPAs, professional HR managers, independent HR consultants or your CFO. They'll review your workers, the conditions of their employment and how they are being paid and classified. For example, did you know that you might have to pay overtime to salespeople working on commission?

If your consultant spots problems in your compensation structure, you need to correct them immediately. The penalties for noncompliance can be severe. Courts routinely award liquidated damages, which can be double any unpaid overtime going back two years from the time of a complaint. Multiply this by a large number of employees (and past employees), and you're talking real money.

Now that we've got the legal mumbo jumbo out of the way, I can move on to the considerations that you can make on your own. Start with the economics of your industry. Is it typically based on hourly pay or salary? There's usually a good reason it has adopted whichever structure it uses; deviating from that may lead to higher compensation costs than you can sustain.

Still can't find solid answers? Fall back on this general formula: If you regularly need to ramp your head count up or down--say, on a monthly or seasonal basis--then it usually makes more sense to pay an hourly wage. But to retain a stable work force with high skills and low turnover, salaries are a better bet.