The Importance of Pay Differentials

What Are Pay Differentials?

Pay differentials are conditions for which an employer is willing to compensate an employee with additional wages. Much depends on the company’s compensation philosophy, history, and pay practices. Pay differentials can often be an important aspect of getting compensation right because they can help entice employees to take certain less desirable assignments, such as evening, night, or weekend shifts, on-call or call-back pay, or hazard pay, or recognize employees with specialty/certification pay. For companies operating in different states, an effective compensation planning strategy should include comparison of relevant labor markets, which may vary widely, for pay differentials based on the geographic locations of the labor force. One of the most important overall planning strategies is to create equitable compensation across labor markets for the entire workforce.

How Are Pay Differentials Used in Compensation Planning Strategies?

There are different methods for determining geographic pay differentials, with two of the most popular being differentials by job and differentials by structure. This blog is focused on the former method, using a tool such as SalaryExpert’s, powered by ERI, Salary Assessor. Look for a discussion of the latter method, using a tool such as our Geographic Assessor, and a comparison of the two approaches in future blogs.

Companies should consult salary survey data to determine the variation of pay across the relevant states and locales where they operate. Salaries across the United States can fluctuate significantly based on where jobs are located. Most commonly, employers leverage salary differential data when budgeting for large, multi-location hiring efforts. However, an organization hiring for the same job in multiple labor markets might know what salaries to pay employees at their current location but not necessarily the pay differentials in unfamiliar markets.

There could be far-reaching budget implications if compensation planning does not account for the appropriate deviations in relevant labor markets. For example, the labor market for an Administrative Assistant may be lower in Orange County than in Los Angeles across industries; however, with the shortage of Clinical Laboratory Scientists, Orange County must now compete with the Los Angeles labor pool. This increased competition requires the organization to pay much higher salaries than once was the case. Geographic differentials are market-driven pay variations between locations. Companies use these differences when pricing the same job in different geographic markets.

The objective is to control costs where it is not necessary to pay at higher levels, or to ensure adequate pay in areas where the market is much higher than the national average. It is an adjustment based on the cost of labor, not the cost of living. Creating and adopting the use of pay differentials may be needed to recognize recruitment and retention difficulties, as well as special professional or educational certifications creating hot jobs. In addition, geographic differentials can make it easier to conduct internal equity reviews or discrimination analyses.

Companies should perform a comprehensive job-by-job market analysis regularly to effectively implement pay differentials. As with all compensation, pay differentials should be applied consistently and fairly, adhering to federal and local regulations. Establishing written policies and procedures outlining eligibility, application, and advance approval by management is essential. To easily identify and understand pay components, pay differentials should be identified on a separate line on the employee’s paycheck.

If you are using geographic pay differentials by job, be certain to perform appropriate market analyses and job benchmarking specific to your industry and job locations when you create pay differentials. Determine if you are recruiting nationally or locally for each job or job grouping. (Non-exempt, lower-paid jobs are usually recruited in the local labor market, whereas senior and executive-level jobs may be recruited on a national level.)

Your standard for decisions about implementing geographic pay differentials should be the degree to which there are verifiable differences in competitive salary levels across labor markets. Presumably, your compensation philosophy is based on the intention to pay people competitively and fairly. Use sound methodology – the basic principle that employees expect equal pay for equal work.