Salary compression

In competitive job markets, businesses lacking an in-demand skill set sometimes pay more for it than they did previously. This recruitment tactic may land the desired talent and solve the immediate problem, but it may also inadvertently cause another issue – wage compression. If left unchecked, it can negatively affect the workforce and the business.

Wage compression definition

What is salary compression?

Salary compression, also known as wage or pay compression, occurs when employees receive comparable compensation despite differences in their experience, qualifications, responsibilities or tenure. The most common example is a new hire who makes nearly the same salary as a colleague in a similar role who’s been with the organization for several years.

What is the difference between salary compression and salary inversion?

Pay compression is usually a minimal difference in compensation between employees who should be at opposite ends of the pay scale. When new hires earn as much or more than tenured employees, it’s known as pay inversion.

What causes pay compression?

Wage compression is generally not a deliberate act on behalf of an employer. Some may not even know they have a pay scale problem until they start experiencing its deleterious effects, e.g., high turnover. In most cases, wage compression occurs inadvertently over time due to internal and external forces, such as the following:

• Regulatory changes – Increases in the minimum wage or the salary threshold for overtime exemption can result in entry or junior-level workers making nearly as much as employees with more experience or responsibility.
• Market rates – Demand for certain skills fluctuates periodically. When this happens, new hires with the same qualifications as tenured employees might earn comparable compensation.
• Long-tenured employees – Employees who stay with an organization for a long time and only receive small, incremental raises could end up earning the same as newer employees with less experience.

Why is compression pay a problem?

Wage compression can make employees feel they aren’t being paid fairly for their efforts. As a result, employers may notice poor engagement and morale, decreased productivity and increased turnover. Brand reputation and recruitment can also be harmed if employees express their frustrations publicly.

How to identify pay compression

Employers should regularly assess if wages are starting to compress across their organization. They have several tactics at their disposal:

• Compare new hire compensation to what current employees in similar roles earn.
• Identify if employees are clustered at the top of the salary ranges for their position.
• Use compa-ratios to determine if entry-level and senior-level employees are moving through salary ranges at the same pace.

How to fix pay compression

Correcting wage compression requires data analysis and talent activation. Some of the basic approaches include the following:

• Create a compensation policy that outlines how the company will use compensation to achieve its talent objectives.
• Implement pay-for-performance so employees receive raises based on merit rather than tenure alone.
• Conduct a benchmark analysis and adjust the pay of any employees paid below the current market rate.
• Provide opportunities for advancement so employees can earn more as they grow with the company.

How to fix salary compression in smaller companies

Rectifying compensation compression can be expensive, especially if it has gone unnoticed for some time. However, small businesses that can’t afford to raise base salaries to the current market rates are not without remedies. They can reward employees with other perks, such as:

• Additional paid time off (PTO)
• One-time bonuses
• Flexible schedules
• Remote or hybrid work
• Career development resources

Frequently asked questions about the salary compression meaning

Is salary compression illegal?

Wage compression is not illegal. However, any unfair pay practices that are discriminatory can result in legal consequences.

How do you overcome salary compression?

Rectifying salary compression starts with having a sound compensation management strategy and pay scales based on skills, experience and performance. Employers must then analyze benchmark data to ensure they’re paying people at or near the market rate.

What are some non-cash ways to reduce compression salary issues?

If employers cannot afford to address wage compression with immediate pay raises, they can offer their employees career advancement opportunities, additional PTO, flexible schedules and remote or hybrid work arrangements. These non-cash incentives may help maintain engagement and productivity until the employer can align compensation levels with the current market rates.

How can you help employees understand that you’re trying to be fair with wages?

Many employees believe they are paid fairly when their employer is transparent about compensation. As such, employers should share their compensation policy with employees and ensure they understand how the pay scales were created and the rationale for raises.

This article is intended to be used as a starting point in answering “What is wage compression?” and is not a comprehensive resource of requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.