What Is Pay Compression?

Pay compression occurs when employees’ compensation does not accurately capture their experience level or skill set. Here’s why it’s bad for your bottom line.

Written by Megan McNamara
Published on Jan. 25, 2023
What Is Pay Compression?
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Pay compression, also known as wage compression or salary compression, occurs when employees with significantly different skill sets or experience levels have nominal differences in pay. Pay compression can happen, for example, when a new hire is paid more than (or close to) the rate of an employee who has been in the job for a long time.

Why Does Pay Compression Happen?

  • The minimum wage increases
  • Rapid inflation
  • Talent demand exceeds supply
  • Your compensation data is out-of-step with external market data
  • Pay bands that are too broad
  • Inconsistent pay practices within an organization
  • Corporate mergers
  • Starting salaries set too close to existing employee salaries
  • Economic downturn leads to a wage freeze

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What Causes Pay Compression?  

Pay compression is usually an unintended consequence due to outside forces, such as a merger of two companies, federal or state minimum wage increases, or rapid inflation. That said, a company’s internal pay structure can also contribute to pay compression. This can happen when starting salaries are set too close to the wages of existing workers. An organization desperate to attract talent may boost compensation to make an offer more enticing in a competitive job market, but they may not have the room to increase pay for existing employees. 

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What Are the Risks of Pay Compression?

When an organization boosts pay to attract new hires and doesn’t provide corresponding market salary increases for existing staff, you may see a drop in employee retention. After all, a senior employee who discovers they’re being paid less than a new employee isn’t likely to stick around.

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How to Combat Pay Compression

First, it’s crucial to be up front about your company’s compensation philosophy and actions so your workers understand how their pay is set. This preventative measure can help stave off concerns of pay compression. Human resources departments need to work closely with finance teams to address any potential pay compression issues, create a compensation philosophy, then set pay grades and salary ranges according to this plan. The compensation team should also review job descriptions to ensure payment aligns with the nature of an employee’s responsibilities. 

A business can choose to lag, match or lead the market with compensation packages. Lagging the market typically makes it harder to recruit high-quality talent. On the other hand, leading the market can attract talent and keep current workers motivated. Businesses should review and evaluate their compensation philosophy every few years to ensure their actions continue to align with the plan.

Other methods to address pay compression include:

  • Offering sign-on bonuses for new hires instead of higher base pay
  • Hiring more hourly workers to reduce required overtime
  • Making base salary adjustments for existing employees
  • Setting higher merit increase budgets for high-performing workers
  • Offering additional paid time off
  • Making off-cycle, mid-year adjustments to equalize current and new employees’ pay
  • Implementing cash bonus awards

While pay compression is a fairly common phenomenon, it’s crucial for HR teams to develop a compensation plan ahead of time so they can make minor tweaks to stop pay compression in its tracks. In the end, a clear compensation philosophy and plan to adjust employees’ compensation now will be less costly than ignoring the issues in the long run. Pay compression leads to turnover and high turnover rates are expensive and time-consuming for human resources, hiring managers and leadership, not to mention the strain high turnover puts on other employees.   

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