Discretionary Bonus Guide for Employers

A discretionary bonus is one of the types of bonuses that might be awarded by an employer. Some employers award discretionary bonuses to recognise an employee’s performance, as a thank you for referrals or to avoid the risk of having to recalculate any overtime compensation at the end of the year.

Many employers give their employees discretionary bonuses or commission. However, “discretionary” does not mean that employers can pay whatever amount they choose.

For some employees in sectors such as insurance, bonuses and other variable compensation (such as stock options) will form a substantial proportion of their annual remuneration. As such, this area is ripe for grievances and legal claims from employees who are disgruntled with their treatment and employers need to be particularly mindful of their obligations.

Commission and bonus payment disputes arise on a regular basis between employers and employees. Employers often refuse to pay outstanding commission or bonus when an employee leaves to go and work for someone else but in extreme cases some employers refuse to pay whilst a person remains in employment, citing a variety of often plausible reasons for their failure to do so.

 

What is a discretionary bonus?

 

A discretionary bonus is extra compensation that a company gives to an employee to reward exceptional performance, an accomplishment or contribution that goes above and beyond regular duties for the job.

To be awarded as a discretionary bonus, the payment must be made at the discretion of the employer at or near the end of a bonus period and the employee cannot expect to receive the bonus regularly. While many companies choose to award discretionary bonuses once or twice per year, they’re not obligated to do so.

 

When is a discretionary bonus awarded?

 

Because a discretionary bonus is considered compensation that involves extra pay and because it is awarded at the sole discretion of the employer—without the employee knowing in advance—it isn’t possible for employees to predict their own discretionary bonuses. This additional compensation is periodically awarded for specific or unexpected reasons and are not part of the employee’s contract. While many companies provide discretionary bonuses once or twice per year, they aren’t under any obligation to do so unless the employees are promised the bonus in advance.

 

Common methods for calculating a bonus

 

Here are some of the different methods that an employer might use to calculate a bonus:

 

Percentage of sales

To calculate the bonus this way, the employer would multiply the employee’s total sales by the designated amount.

Bonus per sale

For a bonus per sale, the employer would multiply the designated bonus amount by the number of sales that the employee made.

Designated sum divided

To calculate this bonus, the employer would designate a total amount for bonuses and then divide it by the number of employees.

Number of hours worked

To calculate a bonus based on hours worked, you add the total number of hours that each employee worked, divide the total bonus by the total number of hours to determine the amount per hour and then multiply the per hour bonus amount by the number of hours each employee worked

 

The law on discretionary bonuses

 

It will sometimes be the case that the mechanism for calculating an employee’s bonus entitlement will be set out explicitly in writing, either as part of their employment contract or in a separate bonus plan document or side letter. In this case, any failure by the employer to follow the express agreement between the parties will result in a right for the employee to claim damages for breach of contract. Of course, the correct interpretation of the contractual wording may be open to dispute, in which case the employer would be advised to seek legal advice before finalising the employee’s bonus allocation.

Often, though, the employee’s contract will state that the employer has discretion to set the bonus, either absolute (i.e. the payment of any bonus is completely at the employee’s discretion) or partial (i.e. the employee is entitled to be considered for an annual bonus, but the employer has discretion to determine its quantum). In such cases, it would seem that the employee would not have any basis to bring a claim if the employer chooses to exercise that discretion to award a bonus which is lower than the employee believes is justified. However, through the English case law in this area, some limitations on the exercise of the employer’s discretion have been developed.

The legal principles derived from those cases overlap, but can be summarised as duties on the employer:

 

• to exercise discretion honestly and in good faith;
• to not exercise discretion in an arbitrary, capricious or irrational way;
• to not exercise discretion in a manner that breaches the mutual ‘trust and confidence’ implied into all employment relationships.

 

The key case on the principle of ‘rationality’ in this context concerned an equities trader who had a contract which provided for a discretionary bonus based on his individual performance. He had earned profits in excess of £5+ million in the months before his dismissal and had also been responsible for a deal that would produce a further £15+ million. Despite this, he received no bonus, whereas all other traders received substantial bonuses (including one who made a loss). The Court held that a decision would be irrational if no reasonable employer would have decided to exercised its discretion in that way. On that basis, it found that the employer’s decision not to award the employee a bonus was plainly perverse and irrational.

In an attempt to avoid this result, bonus clauses will often provide that the employee is only entitled to receive a bonus where they are still employed and not under notice as at the bonus payment date. The case law generally supports the enforceability of this approach and so it would be prudent for employers to include this type of wording in their contracts.

An employer’s discretion could also be restricted by virtue of its previous custom and practice. Even if a bonus is stated to be discretionary, if the employer has paid bonuses in a consistent manner over a period of years there is a risk that an employee may succeed with a claim that the right to a bonus has become an implied term of their contact.

This is a particular risk where the employer has recorded the basis for calculating bonuses in a written document, such as an incentive policy. While that written document may state that its terms are non-contractual and may be varied by the employer, if bonuses have been paid out consistently in accordance with its terms then there is risk that it may become part of the employment contract.

Employers with a written non-contractual bonus scheme would therefore be well-advised to take steps to protect its discretionary status, for example by regularly re-iterating the non-contractual nature of the scheme, periodically varying its terms, and applying a degree of judgement in determining individual allocations rather than rigidly following the written criteria.

 

Employee entitlements to a bonus

 

Whether an employee is entitled to bonus payments depends on whether there is an agreement between them and their employer.

If there is an express term in the contract saying they will be paid a bonus, or an implied term by virtue of custom and practice, then they have a contractual right to a bonus, meaning that if the employer fails to pay the bonus when due, this would be a breach of contract.

If the contract makes it clear that the bonus is paid at the employer’s discretion, then they may not be contractually entitled to the payment. But, even if the bonus is discretionary, the employer must not:

 

• act irrationally or arbitrarily;
• breach the contractual duty of trust, confidence and good faith; or
• victimise or discriminate – for example, by withholding a bonus because an employee has asked to return to work part-time after maternity leave.

 

How to reduce the legal risks of discretionary bonuses

 

Employers who want to avoid challenges by employees about how they have exercised their discretion:

 

• Have in place an appropriately worded clause in the contract of employment setting out that a bonus/commission is discretionary.
• Consider the reason(s) for the amount of bonus/commission you are giving to an employee.
• Record your reason(s) in writing at the date the bonus/commission decision is made so that you have evidence ready in the event of a challenge. Your record should show why and how you have reached a decision. Flipping a coin is not a rational decision-making process!
• If you want a bonus/commission scheme in place, ensure that this is suitably worded to give you flexibility. For example, the flexibility to vary or withdraw a scheme can be a useful tool.
• If you tell employees there are factors that will be taken into account in decision making (for example, in a commission scheme), ensure these factors are taken into account. If the factors change, tell employees in advance of them carrying out the work.
• Treat staff consistently. If an employee feels that they have been awarded a lower commission/bonus than others, they may claim this is on the basis of a protected characteristic (such as age, sex or disability). This could leave an employer facing a discrimination, as well as a breach of contract, claim.

 

Discrimination

 

In determining bonuses employers must not discriminate by treating employees less favourably because of protected characteristics. These protected characteristics include sex, race, religion or belief, disability, age and sexual orientation. There have been a number of bonus cases where the Courts have found that employers have discriminated against employees.

 

Other types of bonus

 

Here are some other types of bonuses that companies award their employees:

 

Contracted

Many executives have in their contracts that they will receive bonuses, although they are often contingent on the company achieving specific revenue targets. The employer may also base the bonus on other methods as well, such as employee retention, sales or growth goals.

 

Performance

Employers often reward based on different types of performance goals. For example, they may give bonuses for meeting or exceeding personal goals. They may also award bonuses for helping the company exceed its financial goals. Some companies will award larger bonuses to employees who have higher salaries. For example, if an employee makes £50,000 they may be eligible for a five percent bonus for helping the company achieve its financial goals, while an employee who makes £100,000 may be compensated with a 10% bonus.

 

Sales commissions

Sales commissions are also referred to as bonuses, although, unlike other bonuses, they are directly tied to your sales performance. Some companies place a cap on the amount of compensation sales representatives can receive in a bonus.

 

Need Assistance?

 

DavidsonMorris’ HR specialists support employers with all aspects of employee reward and recognition, and related contractual implications. Working closely with our employment lawyers, we provide comprehensive guidance on how to approach employee rewards to optimise engagement and return, and nurture positive and healthy working cultures. For help and advice, speak to our experts.

 

Discretionary Bonus FAQs

 

What is a discretionary bonus?

A discretionary bonus is a payment made by an employer to an employee that is not guaranteed and is given at the employer’s discretion. Unlike contractual bonuses, there is no obligation for the employer to pay a discretionary bonus unless they choose to do so.

 

How does a discretionary bonus differ from a contractual bonus?

A discretionary bonus is given at the employer’s choice and is not promised or guaranteed in the employee’s contract. In contrast, a contractual bonus is agreed upon in the employment contract and must be paid if the specified conditions are met.

 

Can an employee challenge the decision not to award a discretionary bonus?

While discretionary bonuses are not guaranteed, employees can challenge the decision if they believe it was made unfairly, discriminatively, or in violation of the implied terms of trust and confidence in their contract.

 

Are discretionary bonuses taxable in the UK?

Yes, discretionary bonuses are subject to income tax and National Insurance contributions in the UK, just like any other form of income. Employers are responsible for reporting these payments to HMRC.

 

Can a discretionary bonus be included in an employee’s regular pay?

No, discretionary bonuses are typically separate from regular pay. They are usually paid as a one-off or irregular lump sum and are not included in the employee’s standard salary or wages.

 

Is there a best time to pay discretionary bonuses?

The timing of discretionary bonuses varies depending on the company’s practices and the intended impact on employee motivation. Many employers choose to pay bonuses at the end of the financial year, after performance reviews, or around festive periods like Christmas.

 

What factors should be considered when deciding on a discretionary bonus?

Employers should consider factors such as company performance, the individual employee’s contributions, market trends, and the overall fairness and consistency of the bonus distribution across the organisation.

 

Do discretionary bonuses affect employee morale?

Discretionary bonuses can positively impact employee morale if they are perceived as fair and linked to performance. However, if not managed well, they can lead to dissatisfaction, particularly if employees feel the criteria for awarding bonuses are unclear or inconsistent.

 

How can employers ensure fairness in awarding discretionary bonuses?

To ensure fairness, employers should establish clear criteria for awarding bonuses, communicate these criteria transparently to employees, and apply them consistently across the organisation. Regular reviews and audits of bonus practices can also help maintain fairness.

 

Glossary

 

Term	Definition
Discretionary Bonus	A bonus awarded at the employer’s discretion, not guaranteed or promised in the employee’s contract.
Contractual Bonus	A bonus that is specified in the employee’s contract and must be paid if certain conditions are met.
National Insurance (NI)	A system of contributions paid by employees and employers in the UK, which helps to fund various benefits including the state pension and the NHS.
HMRC	Her Majesty’s Revenue and Customs; the UK government department responsible for tax collection and the administration of other regulatory regimes.
Employment Contract	A legally binding agreement between an employer and an employee that outlines the terms and conditions of employment, including pay, working hours, and bonuses.
Performance Review	A regular assessment of an employee’s job performance, usually conducted annually or semi-annually, which can influence decisions on bonuses.
Tax Efficiency	Strategies used by employers and employees to minimise tax liability, ensuring that tax payments are legally optimised.
Employee Morale	The overall attitude, satisfaction, and confidence that employees feel at work, which can be influenced by rewards such as bonuses.
Trust and Confidence	An implied term in employment contracts, indicating that both employer and employee must not act in a way that is likely to destroy or damage their relationship of mutual trust.
Fairness	The quality of making decisions that are free from bias, dishonesty, or injustice, particularly important in the context of awarding discretionary bonuses.
Grievance	A formal complaint raised by an employee regarding workplace issues, which could include disputes over bonus payments.
Lump Sum	A one-time payment made in a single instalment, as opposed to being spread out over time. Discretionary bonuses are often paid in lump sums.
Market Trends	The prevailing conditions and directions in a particular industry or economy, which can influence the size and frequency of discretionary bonuses.
Taxable Income	Any income that is subject to income tax, which includes wages, salaries, and bonuses such as discretionary bonuses.
Bonus Distribution	The process of allocating bonuses to employees, which should be carried out fairly and transparently.