What Pay Compression Is — and Why You Must Avoid It

You’ve just hired someone. You’re paying them nearly the same amount that you give longer-service employees for the same job. By doing this, but you’re likely engaging in pay compression.

Pay compression happens when a new employee is paid nearly the same as or more than a longer-service employee in the same role. For instance, a new hire with little experience earns more (for the same job) than an employee who’s been with the company for years. Or, a new hire and a longer-service employee both have similar skill sets, but the new hire’s pay is only slightly less than the latter’s.

You can also be engaging in pay compression if you pay a lower-level employee nearly the same as or more than their manager (or supervisor). For example, an exempt-salaried manager (who does not qualify for overtime) ends up earning less than a nonexempt-hourly direct-report (who does qualify for overtime).

Causes of pay compression

• Outdated pay practices that do not reflect current market conditions. For example, the market rate for the position has risen, and you’ve set the new hire’s pay range to align with that increase. However, longer-service employees in the same job are still receiving the old market rate.
• Improper promotion practices. For example, a longer-service employee is promoted and therefore takes on extra responsibilities, including leadership duties. Despite the promotion, they are earning less than one of their direct-reports or a new hire in a similar role.
• Minimum wage increases. This may cause a new hire to receive the same minimum wage as employees who have been with the company for several years.
• Pressure to secure candidates with in-demand skills, especially in a tight labor market. To lure the candidate in, the employer offers higher pay, ignoring the potential impact on current employees in the same job.
• Economic downturn that results in pay freezes. Once the economy bounces back, candidates may request higher pay that outpaces existing employees’ frozen salaries.
• Merger or acquisition, such as when the companies involved have different approaches to compensation.
• Disproportionately providing additional pay — such as in the form of overtime wages, stipends, and bonuses. Excessive overtime, for example, may cause a nonexempt direct-report to out-earn their manager.

While pay compression can be intentional, in many cases, it is unintentional. Regardless, the practice can be damaging to the organization.

While pay compression can be intentional, in many cases, it is unintentional. Regardless, the practice can be damaging to the organization.

Consequences of pay compression

• Employees viewing your pay practices as unfair
• Low morale among longer-service employees, leading to disengagement
• Loss of employee trust in your company
• Difficulty recruiting from within, as employees may not see any value in accepting a promotion
• Increased turnover, as employees jump ship for greener pastures
• Newly departed employees “spreading the word” about your unfair pay practices. This not only impacts your business’ reputation but may also cripple your ability to attract qualified candidates
• Employees filing lawsuits or complaining to the federal or state labor department, alleging unfair pay practices. Or they may lodge a complaint with the Equal Employment Opportunity Commission (EEOC), citing pay inequity

If you’re wondering how existing employees would know what new hires in similar roles are earning, remember that except in limited cases, employees are allowed to discuss their pay with coworkers. Plus, “news” about pay tends to travel fast in the workplace.

Suppressing pay compression

On the upside, pay compression can be fixed — and the sooner the better.

Tips for handling pay compression

• Analyze the salary range for each position and compare them to the current market rates. This lets you spot pay inequities and adjust them to reflect market conditions.
• Make “equity adjustments. Raise the pay of longer-service, high-performing employees.
• Offer longer-service employees other types of rewards if you can’t close the pay gap through salary increases. Some options include bonuses or additional PTO.
• Ensure your pay structures consistently align with market rates.
• Compare employees’ job descriptions with their actual responsibilities. See whether the descriptions need to be rewritten and whether pay ranges should be modified.
• Determine whether each employee’s job performance is commensurate to their pay. 
• Audit your compensation plan regularly. Verify whether employees are being paid according to their responsibilities, performance, and experience.
• Stop or lower pay increases for overpaid employees, until their pay becomes equitable.
• Find ways to control overtime. For example, if an employee out-earns their manager due to overtime, you can hire another employee to decrease per-worker overtime.
• Compare managers’ salaries to direct-reports’ pay. If the numbers are too close (e.g., a lower-level employee making over 90% of their manager’s salary), then wage compression is likely present.
• Pay attention to your salary range midpoints, as this is where new-hire salary typically starts. For example, if a new hire’s pay falls in the third or fourth quartile of the salary range and a longer-service employee in the same job is still at the midpoint, there may be a case of pay compression.

It’s critical to pinpoint the root causes of pay compression and then promptly correct them. If outdated HR processes are a factor, it may be time to modernize your HR system.

Check out our People Ops Podcast episode “Compensation planning; where do I start?”