The Basics of a Compensation Contract: Important Provisions and Guidelines

Compensation Contract 101

The definition of a compensation contract is rather simple; it is an agreement governing the duties and obligations of an employee and employer in the event of a termination of the employment relationship. The employment law at the provincial level generally governs the compensation contract, also known as the termination contract.
As a employer, it is important to understand the compensation contract as it is this agreement that will govern the employer’s liability for any amount owing to an employee as a result of the termination of employment. This may include: any bonus due and owing , salary, vacation pay, severance or other benefits. As such, the agreement is crucial as it is a finite contract that will very much limit your liability.
As an employee, what the compensation contract will truly do is give clarity in terms of how much you are entitled to in the event of a termination. It means that both parties should be aware as to how much they will owe and be owed in the event of a termination. It can limit and clarify the costs and potential risks associated with litigation.

What Should Be Included in Your Compensation Contract

The backbone of any compensation contract is the base salary, which serves as the fixed amount of money that a company will pay an employee for a specific job. Generally speaking, the base salary is most commonly paid on an hourly basis, typically calculated on a weekly or bi-weekly basis. Some companies also offer commission, which is a type of incentive payment calculated as a percentage of the revenue an employee generates. Bonuses can also be included in a compensation contract and are typically made one or two times per year based on certain performance targets. These can be tied to sales, company revenue or even revenue from a specific territory, department or other factor. Stock options are another component that is often included in compensation contracts and offers employees the ability to buy company stock at a predetermined price after a certain period of time. Some contracts also include benefits, which cover a variety of expenses that support an employee’s life outside of their current position. For instance, this may include health insurance, life insurance, retirement plans, paid time off and other similar factors. The main goal of a compensation contract is to be as clear and specific about each of the components of the contract as possible. The more detail that is provided for each component, the less likelihood that there will be confusion about the terms of the document. If any part of the compensation package changes during employment, such as a bonus structure or stock options, an addendum can be created as an amendment to the original contract, so long as these are correctly documented and signed by both parties.

Legal Aspects of a Compensation Contract

In addition to the elements outlined in the previous section, compensation contracts must comply with relevant employment and anti-discrimination laws. Compensation packages should not discriminate based on age, race, gender, religion, sexual orientation, or any other protected class. Employers also should be aware of the implications of pay equity laws in their jurisdictions, and structure compensation agreements accordingly.
Compensation agreements are generally offered as an extension of employment at will, but they can be legally binding if the terms and conditions rise to the level of a contractual obligation. Where this is the case, compensation agreements should always contain an explicit signed statement indicating that the terms cannot be altered except for in writing and signed by all parties involved. When an oral contract is implied by the actions of the parties, either explicitly or implicitly, the agreement is equally as binding. Under those circumstances, an employer cannot unilaterally modify the terms of the written contract without good cause.

Common Pitfalls in a Compensation Contract

A significant portion of the work we do for clients involves drafting and revising compensation contracts. A few of the more common mistakes we see are: Compensation Contracts Are Not for All Time Sometimes clients think of compensation contracts as binding for all time. In other words, they may decide some day to change compensation. But unless the contract says you may do so, that’s a problem. Retain the Option to Change Compensation. Whether or not you will be entitled to change compensation when you want is up to you. If you want that ability, then state it in the contract. The contract should say something like "Employer may revise bonuses and commissions from time to time when appropriate, in its sole discretion." For good measure, the contract should state that the prior sentence does not alter the at-will nature of the employment relationship. Don’t Have Unclear Language in the Contract if You Don’t Need It Does the contract need to say that you can advertise that someone made some huge bonus or commission? No. (I am positive that if you need such a clause I can come up with something for you, our rates are reasonable). But don’t leave it out of there if you need it. Don’t Make It Hard to Change the Compensation Contract If your contracts don’t have a clause saying that they can be revised, they can’t be. I know you think that to be true, but unless the contract has a provision allowing change, don’t expect it to happen. Therefore, don’t make it hard to change if you may want to. For example, add on "Employer may revise this agreement upon giving [xx] days’ notice to Employee." Many people, when they hear the word "contract," think that it means something written down and signed. But an oral modification of a contract is a contract modification. It is a little harder to prove, but is entirely possible. For example, conduct by the parties after the contract was signed in accordance with an alleged oral modification will go a long way to proving what was in fact agreed to. If you want to rely on such a thing (which you should not, for reasons I will explain) then you need to add some language like this: "This contract may not be modified orally or in writing except by a writing signed by both Employee and Employer". If it is not such a contract, negotiate for something like this. Failure to Update Contracts If your contracts are not up to date with the law or if they have otherwise gotten stale, do not use them. If you use a compensation contract that is backwards looking, a judge, jury, or arbitrator might consider that a stiff sentence. But in addition to keeping contracts current, don’t ignore the implications of the contract when making changes to the compensation plan. It is too easy to forget that existing contracts may require you to give two weeks’ notice before you make changes. For example, consider this too: If a contract specifically allows you to make changes upon notice, is that enforceable? Yes, that is enforceable. Just like an employer generally can reduce pay upon notice. See above. But sometimes you think you need to show some hardship to make a change. Consider this (do not use): This contract may not be modified orally or in writing except by a writing signed by both Employee and Employer. Employer may terminate this contract or revise the base salary, commission, or bonus upon giving sixty days’ advance notice to Employee. And you unilaterally cut the commission and give sixty days’ notice. Is that enforceable? Probably not. Do not use any provision that takes away that right. I cannot tell you how pervasive this is in the field. What if You Have No Contracts? If you do not have any written contracts, keep using the practice of giving notice. It should usually be enforceable. Putting it down in writing is always better, however. Recall that even if the law says you do not have to give notice of changes, or of a termination that is given at-will, if you do so, it may lessen the chance of litigation.

Negotiating a Compensation Contract

Negotiating a compensation contract can be a complex process, but there are several strategies both employers and employees can use to help ensure a fair and successful outcome. For employers, it’s important to have a strong understanding of industry standards and the specific requirements of the position in order to offer a competitive, yet financially viable, compensation package. Employees should enter into negotiations well-informed of their worth in the market, as well as what they can reasonably expect to earn from the position. In addition to salary, there are a variety of benefits and other criteria that can be included in compensation contracts. Working from within this broader scope can help employers better attract and retain employees and also allow employees to secure a more lucrative package . Possible points of consideration for employers and employees include: Even if a compensation package is ultimately agreed upon, there is still legal work to be done. Both sides should be certain that all agreed-upon terms are included in the final contract, which should provide a clear roadmap of what is expected going forward. For example, employee payment terms should spell out exactly how much the employee will be paid, when and how those payments will be delivered, and exactly what the employee is expected to do to earn that compensation. This type of transparency helps avoid any confusion down the line and also helps identify red flags that may arise during negotiations.

Current Trends and Innovations in a Compensation Contract

In recent years, the landscape of work has transformed drastically, ushering in a myriad of new trends in how businesses formulate compensation contracts for their employees. Many of these trends are a direct response to workers’ evolving needs, but they also reflect the flexible and adaptive nature of corporate compensation structures. For example, the COVID-19 pandemic forced many businesses to quickly adopt remote work arrangements. As a result, a growing number of compensation contracts now include provisions for telecommuting and remote work. These innovations not only clarify the policies surrounding remote work, but they also serve to boost employee morale by enabling workers to make their own schedules and working conditions more conducive to their unique lifestyles.
Another trend in compensation contracts is the incorporation of flexible benefits packages and plans. With our society becoming increasingly focused on "work-life balance," flexible benefits plans allow workers to make choices about their health care, paid time off, and workplace contributions based on their individual situations. Such arrangements create a sense of ownership within employees, increasing their level of satisfaction with their overall work experience.
Furthermore, it should come as no surprise that business leaders continue to explore new ways of offering workers performance-based incentives. A growing number of companies are beginning to tie bonuses and raises to workers’ respective performances. This trend encourages diligence and perseverance while providing employees with a way to financially benefit from their efforts. Since many businesses are implementing performance-based pay at the management level, more organizations are formally defining their compensation structures for middle- and lower-tier workers. This, too, helps create a workplace environment that facilitates growth, both personally and professionally.
Indeed, the innovation behind compensation contracts demonstrates a willingness to embrace change. A number of factors – from outside markets to evolving cultural values -can compel businesses to regularly update their employment compensation contracts. In these times, the most competitive organizations tend to be those that are able to do just that.

Examples of Successful Compensation Contracts

The technology sector has been an early adopter of well-crafted compensation contracts, particularly those agreements that align compensation to performance. For instance, a prominent Silicon Valley software firm adopted an annual compensation contract that was based not just on achieving internal metrics but also on contributing to a number of critical initiatives, including employee engagement and retention. The contract helped to retain valuable employees who were being headhunted by other firms in the area, and significantly increased the management pipeline of the firm.
The healthcare industry has turned to compensation arrangements over the past several years to better attract and retain physicians. A mid-size hospital was spending considerable amounts of money to fill vacancies in its emergency department . The hospital now requires these physicians to enter into an annual contract that compensates them for availability, patient service and quality, mentoring, metrics, and innovation. Importantly, physicians are required to accept relocation bonuses, and the contracts require that a portion of the bonuses be repaid at the same times and in the same manner as any bonus or incentive payments should the physician leave before the end of the contract.
A public relations company with offices in several major cities joins competitors in offering guaranteed employment and unfettered use of vacation and leave benefits. However, unlike its competitors who offer no termination notice, the company requires all employees to enter into severance contracts. Employees receive one month of notice plus a week of severance for every year of service at the firm. The contracts have acted as a retention tool for the company, which in recent years has seen a surge in the number of repeated and returning clients.